Interest Rate Considerations

With interest rates at or near all time lows, the time is ripe for considering the use of notes in conjunction with gift and estate tax planning.

The low rates make it possible currently to transfer property from one generation to the next at a very low cost. In addition, by combining low interest rate notes with other estate planning techniques, such as utilizing “defective” grantor trusts, grantor retained annuity trusts (GRATs for short), or family partnerships the value of property that may be transferred tax-free may be even greater.

Moreover, the benefit of previous estate planning may be enhanced by substituting new, lower rate notes for old, higher rate notes.

Moreover, the benefit of previous estate planning may be enhanced by substituting new, lower rate notes for old, higher rate notes. Assuming no prepayment penalty provisions in the original note, a borrower with sufficient liquid assets to pay off a higher rate note should do so and then enter into a new borrowing transaction at the current lower rate. If the borrower does not have sufficient liquid assets to pay off the existing note, it may be possible to substitute a lower-rate note without adverse tax consequences. The substitute note should use the appropriate AFR and have a face amount equal to that of the note being replaced. Accrued interest to date should be paid.

Another important consideration when structuring intrafamily loans is the treatment of the interest, i.e., whether the interest paid will be fully deductible. There are four basic types of interest: (1) personal interest, (2) investment interest, (3) passive interest, and (4) trade or business interest. The Internal Revenue Code (“IRC”) allows a deduction for “all interest paid or accrued within the taxable year on indebtedness.” However, the IRC also limits or prohibits the deduction of certain interest depending in part on the type of debt (personal, investment, passive, or business) to which the interest is allocated.

The interest tracing rules under the IRC and Treasury Regulations provide that debt proceeds and related interest expenses are allocated solely by reference to the use of such debt proceeds, and the allocation is not affected by the use of the property that secures the repayment of such debt or interest. In short, interest expense is allocated based on the use of the funds from the debt, not the collateral securing the debt.

In short, interest expense is allocated based on the use of the funds from the debt, not the collateral securing the debt.

Thus, if Generation Two were to borrow $100,000 to buy a new Ferrari, the related interest expense would likely be non-deductible absent a business or investment use for the Ferrari. On the other hand, if loan proceeds were used to purchase taxable stocks and bonds, or to open a franchise food operation, the interest expense would likely be deductible even though the loan is secured by a Ferrari.

There are a few significant exceptions. For example, qualified residence interest is deductible without regard to the use of the proceeds as long as the loan secured by the qualified residence. In other words, if a taxpayer borrows $100,000 to buy a Ferrari for personal use but the debt is secured by the taxpayer's personal residence rather than the Ferrari, the interest is deductible qualified residence interest even though the proceeds of the loan can be traced to the automobile purchase.

Understanding the different categories of interest, the importance of being able to trace the proceeds of loans to a use, the rules for allocating interest based on the use of loan proceeds, and the exceptions to those rules will help the borrower to avoid surprises by maintaining appropriate records to document deductible interest. One word of warning is necessary. If the proceeds of one loan are used to purchase a number of different items, more complicated rules govern the tracing of loan proceeds to use and the tracing of repayments to use. Some odd and unforeseen results can occur under these rules, so we suggest consulting your tax advisor prior to entering into loan transactions where multiple uses of the proceeds are contemplated. This is one area where a little foresight and planning can result in significant tax savings.