Appraising Intra-Family Promissory Notes – Protecting the Wealth

Bad Valuation Planning Is Costly — What Is Important Is Not Complicated

What is an Intra-Family Loan-Promissory Note Transaction?

The typical intra-family transaction is a loan from one family member to another, usually from an older wealthier person to a less wealthy, younger person. One of the current key benefits takes advantage of the applicable federal rate (“AFR”) is lower than the prevailing market interest rate in commercial transactions. These approved (AFR) rates are far below market rates; this allows loans to family members at very low interest rates while still complying with IRS regulations. accident report munich

Some typical examples of uses of Intra-Family Loans and Promissory Notes:

• Promissory note loans to children at low interest rates
• Promissory note loans to trusts at a low interest rate
• Business purpose loans to family members at low interest rates
• Sales of discounted promissory notes to children or trusts
• Promissory note loans to an estates at low interest rates
• Home mortgages loans to family members at low interest rates
• Home improvement loans to family members at low interest rates
• Promissory note loans at low interest rates as vehicles for gifts

What are the advantages and benefits?

If the asset that the family member acquires with the loan proceeds has combined income and appreciation above the interest rate paid on the note, there will be a wealth transfer without gift tax implications. With the current incredibly low AFR interest rates, there is significant opportunity for non-taxable wealth transfer.

Keeping the wealth “all in the family” is a benefit. If the interest payments are made to other family members rather than being paid to banks, family members benefit.

If the borrowing family member has a poor payment history, or a poor credit rating, an intra-family loan may be the only source of needed liquidity.

Borrowing from a bank or other outside lender may entail substantial loan origination costs and closing costs that can be avoided, or at least minimized, with intra-family loans.

What are the red flags and pitfalls of an intra-family loan from an appraiser’s Fair Market Value standpoint?

Let’s look at the facts through the eyes of the note appraiser when appraising and valuing a promissory note for tax purposes, and possibly for an IRS audit. Remember the IRS uses a definition of “Fair Market Value” that contemplates a hypothetical third-party buyer doing an arms-length transaction. That hypothetical buyer wants the highest income and the safest asset for his investment.

It’s not surprising that the intra-family loan falls short in several key financial areas when compared to a typical bank loan. The principally reasons for the short-fall are it was not structured at market rates and at market terms; it was structured to accommodate a specific family member; it was not structured to accommodate the hypothetical third-party, arms-length investor. It has serious valuation impairments; it is “valuation-challenged.”

Examples of the impairment typically found in intra-family loans are: the intra family promissory note loan has a below market interest rate; it has “soft” repayment terms below market standards; it has little or no collateral security supporting the borrower’s signature; it has a poorly document loan file lacking a payment history, financial statement, and credit ratings.

Conclusion

To maximize the appraised Fair Market Value of an intra-family promissory note, remember the following guidelines; use them as a checklist:

• Sign a promissory note
• Establish a fixed repayment schedule
• Set an interest rate at or above the AFR rate applicable
• Secure or collateralize the debt
• Demand repayment
• Maintain records that reflect a true loan transaction
• Do not have a prearranged schedule to forgive the loan
• Lend to borrowers with the ability to repay

Lawrence (Larry) Tepper specializes in the appraisal of promissory notes and cash-flow instruments nationally.

 

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