Sunday, October 28, 2012

Intra-Family Loans - Promissory Notes - Appraisal and Valuation

Basic Information

An intra-family loan is an estate-planning technique using a promissory note. The Internal Revenue Service sets forth rules that allow family members to make loans to other family members at lower interest rates than those charged by commercial lenders, without it being deemed a gift. The lender, usually a parent or grandparent, must charge interest to avoid making a gift to the borrower, but this interest rate may be very low (below market rate), with annual payments of interest only, as contrasted to monthly principal and interest payments. The loan can be structured as a "balloon balance note", meaning the borrower pays interest only during the term of the loan, and then repays the entire principal at the end of the term.

From a cash-flow point of view, an intra-family loan, using this structure can be beneficial for the borrower. Because it benefits the borrower, it is detrimental to the value of the lenders promissory note.

Types of Intra-Family Notes
• Loans to family members
• Installment sales to family members
• Self-canceling installment notes to family members

Intra-family loans create wealth shifting opportunities; wealth can be shifted from one family member to another family member, usually a child or grandchild, without incurring a tax liability. If the child or grandchild can earn a greater return on the amount borrowed than the low interest rate charged on the loan, he or she can keep the excess income with no gift taxes being paid. Wealth is transferred tax-free.

The required interest rate is set by the government monthly; it is called "AFR"--Applicable Federal Interest Rate. The actual interest rate used depends on the length of the loan; all of the current AFRs are very low compared to market interest rates.

Another benefit of intra-family loans is keeping the interest dollars paid within the family rather than paid to an outside party. The loan terms can be tailored to the specific needs of the family-member borrower; the repayment timing of the loan can be tailored to suit the borrower's needs.

Valuation and Discount Facts
The goal of "arm-length" promissory note investing is income generation and income maximization; the lower a promissory note's interests rate, the lower its market value. The appraised value of an intra-family loan note, using the IRS's Fair Market Value guidelines, is less than note's unpaid balance, or its face amount. The Fair Market Value of the note is a discounted value. The reason for this discount is the "AFR"-Applicable Federal Interest Rate, is a below market interest rate. To increase that rate to a market interest rate requires applying a discount to the note's value.

Conclusion: The (AFR) Applicable Federal Rate is a below market rate that devalues the note.

Benefits of a Fair Market Value Appraisal
You, your family, or an estate may own a private party promissory note that is not worth its face value. You may not be aware the note can provide a tax deduction. Depending on the size and the complexity of the individual note, the cost of the appraisal report will typically be between $400.00 and $1,800.00. Paying for an appraisal report may initially seem costly, but, it may result in a very meaningful tax savings. The cost of the appraisal can be viewed as an excellent investment; the tax saving can far exceeds the cost of the appraisal.

The value of a promissory note using the Applicable Federal Interest Rates (AFR) must be discounted to make its yield comparable to a similar promissory note having a market interest rate.

Disclaimer: Information is not advice. This article is for your information; it is not financial, legal or tax advice. The information and opinions provided are based on my own research and experience. Always consult a tax expert and valuation expert for your advice

Lawrence Tepper specializes in:
National Valuation and Appraisal Services That Serve Your Needs
Promissory Notes, Debt Instruments, LLC's Appraised & Valued
Expert Consulting Services

Law Degree /Accounting Minor University of Denver
Colorado Real Estate Broker-- Promissory Notes Specialization
Certified Commercial Investment Member From National Assoc. Realtors (CCIM)

35 + years of appraisal and valuation for Attorneys, CPA's, Estates, Trusts, Administrators, and Financial-Investment Advisors.


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