I. Introduction: The Power of the Private Lender

In a traditional financial system, if a child wants to buy a home or start a business, they go to a commercial bank and pay market interest rates. The bank profits, and the family’s collective wealth leaks out to an institution.

An Intrafamily Loan keeps that profit within the "Fortress." The parents (or the Family Trust) act as the bank. This allows the next generation to access capital at lower rates than a commercial bank would offer, while the interest paid stays inside the family's ecosystem. However, to avoid being flagged by tax authorities as a "disguised gift," these loans must follow strict federal guidelines.

II. What is the AFR (Applicable Federal Rate)?

The IRS does not allow you to lend money to family members at 0% interest. If you do, they will categorize the "forgone interest" as a gift, which counts against your lifetime gift tax exemption.

To prevent this, the IRS publishes the Applicable Federal Rate (AFR) every month. This is the minimum interest rate you must charge on a private loan to ensure it is legally recognized as a "bona fide" loan rather than a gift.

The Three Tiers of AFR:

1. Short-Term Rates: For loans with a term of 3 years or less.

2. Mid-Term Rates: For loans between 3 and 9 years.

3. Long-Term Rates: For loans longer than 9 years.

III. The Strategy: The "Interest Rate Arbitrage"

The goal of the generational wealth builder is to "freeze" the value of their estate and pass the growth to their heirs. Intrafamily loans are a primary tool for this.

The Scenario: Imagine the long-term AFR is 4%, but you have an investment opportunity (like a SaaS company or a real estate development) that you expect will return 10%.

1. The Parent lends $1,000,000 to the Child at the 4% AFR.

2. The Child invests that $1,000,000 and earns 10% ($100,000).

3. The Child pays the Parent $40,000 in interest.

4. The Result: The Parent’s estate only grows by $40,000 (taxable later). The Child keeps the $60,000 "spread" tax-free. Over 20 years, this "leaks" millions of dollars to the next generation without ever triggering a gift tax.

IV. Formalizing the Loan: Avoiding the "Gift" Trap

To protect the "Fortress" from an audit, an intrafamily loan cannot be a handshake deal. It must look, smell, and act like a professional bank loan.

1. The Promissory Note

There must be a written contract specifying the principal, the AFR used, the repayment schedule, and the maturity date.

2. Actual Payments

The borrower must actually make the payments. If the parent "forgives" the payments every year, the IRS may argue the loan was a sham from the beginning.

3. Collateral (Optional but Recommended)

For large loans (like a mortgage), recording the loan against the property provides an extra layer of legitimacy and can allow the child to deduct the interest payments on their own taxes.

V. Advanced Technique: The "Note Sale" to an IDGT

In our entry on Trusts, we mentioned the Intentionally Defective Grantor Trust (IDGT). Combining a HoldCo, an IDGT, and an Intrafamily Loan is the "Triple Crown" of wealth transfer.

1. The Founder sells an asset (like shares in a Holding Company) to the Trust in exchange for a Promissory Note at the AFR.

2. Because it’s a "Grantor Trust," the IRS doesn't see a "sale"—it sees the founder selling to themselves. Therefore, no capital gains tax is triggered.

3. The asset grows at 12% inside the trust, but the trust only owes the founder the AFR (e.g., 4%).

4. The 8% difference stays in the trust for the heirs, completely outside the founder's taxable estate.

VI. Psychological Governance: The Family Bank Rules

While the AFR is the legal floor, the Family Constitution should set the cultural ceiling.

• The "Skin in the Game" Rule: Many families require the child to provide a business plan or put up 10% of their own saved capital before the "Family Bank" will lend the rest.

• The Default Policy: What happens if a child can't pay? The Constitution should specify if the loan is converted to a "gift" (reducing their future inheritance) or if the family seizes the collateral. This prevents siblings from feeling that one person is getting "special treatment."

VII. Comparison: Intrafamily Loan vs. Direct Gift

VIII. Checklist for Implementation

1. Check the Current AFR: The rates change monthly. Lock in the rate on the day the note is signed.

2. Match the Term to the Rate: Don't use a short-term rate for a 10-year loan.

3. Document Everything: Keep copies of the signed note and the bank transfers showing the interest being paid.

4. Consider a "Self-Canceling Installment Note" (SCIN): An advanced version where the debt is canceled if the lender dies, potentially removing the remaining debt from the estate entirely (requires a "risk premium" on the interest rate).

Conclusion

Intrafamily loans are the most efficient way to "starve" the estate tax while "feeding" the next generation's ambition. By using the AFR as your guide, you transform the family from a group of consumers into a Private Lending Institution.

Internal Encyclopedia Links:

• See: The IDGT: The Ultimate Estate Freezing Tool

• See: Gift Tax Exemptions: How Much Can You Give Away?

• See: Promissory Notes: The Anatomy of a Private Contract

• Related to: The Ultimate Guide Part 2 (Critical Mass) & Part 3 (The Fortress)