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Estate Planning with Loan Valuation Discounts

Jun 27, 2024

Personal loans can be a useful tool when a loved one needs financial assistance or an investment. Forgiving that personal loan could be a valuable estate planning strategy, especially with the upcoming gift and estate exemption reduction.

By forgiving a personal loan now as a gift, you could claim a valuation discount and save significant estate tax at the time of your death. However, if you wait until 2026 to forgive a personal loan, you may miss out on this estate planning opportunity. Unless Congress passes legislation, the $13.61M estate tax exclusion will be reduced by 50% on December 31, 2025. 

Below, we outline how forgiving a personal loan can provide significant estate tax savings as a result of changes in interest rates. 

Leveraging Loan Valuation Discounts 

Imagine this: a few years ago, you decided to loan money to a family member, a friend, or their business. You wanted to offer a loan with better terms or rates than a bank would provide or maybe a bank simply wouldn’t lend to them at all. You probably set the interest rate based on the Applicable Federal Rates (AFR). 

As the lender, the personal loan is an asset included in your net worth and taxable estate. If you issue a loan and collect all payments through maturity, your net worth grows by the interest collected over the life of the loan. However, if you forgive the balance due on a personal loan, you are making a gift to the borrower equal to the fair market value of the loan on the date of forgiveness. If the interest rate on the loan is less than the rate a third-party would offer, then the fair market value of the loan is less than the balance due. This is called a discount. 

So, what does all of this have to do with your personal loan? The current interest rate environment is dramatically different than it was a few years ago. Banks are issuing loans with much higher interest rates. As a result, the loan you made a few years ago may qualify for a sizable discount. If the borrower will be a beneficiary of your estate, you may want to consider forgiving the loan at a discount now to reduce your taxable estate and overall estate tax due at death. 

About Applicable Federal Rates 

The Applicable Federal Rates (AFR) are minimum allowable interest rates for bona fide private loans set by the IRS each month. Three separate rates are provided based on the term of the loan:  

  • Short-term (less than 3 years)
  • Mid-term (3 to 9 years)
  • Long-term (longer than 9 years) 

If the interest rate on a loan is set lower than the AFR on the date of funding, then the loan may have unintended income, gift, and estate tax consequences. The AFR rates tend to be significantly lower than the current market rate for comparable debt. For this reason, a large percentage of personal loans to friends and family are set at or just above the AFR. 

Gift and Estate Tax Basics  

To understand what a taxable estate is, you need to understand how gift and estate taxes work. Every person has a basic lifetime exclusion amount which is indexed for inflation. In 2024, this amount is $13.61 million. It represents the total amount of gifts that can be made during someone’s life plus the net estate value at death that are free from estate tax. A 40% estate tax applies to all amounts over the basic exclusion. For anyone who expects to have lifetime gifts and/or net estate close to the exclusion amount, this 40% estate tax can be an enormous burden. Therefore, building an estate plan and taking advantage of planning opportunities has the potential to save millions in estate tax. 

Calculating Fair Market Value 

Let’s say in December 2020, you loaned $2.5 million to help fund your child's startup company. The promissory note establishes that the principal on the note will be due 20 years following the date of issue. The interest rate was set at the December 2020 long-term AFR of 1.31%. The loan was set up as an interest-only loan with interest payments due annually and a single balloon payment due at maturity.  

Four years later, you determine that you would like to forgive the note at the end of 2024. Because the note is interest-only until maturity, the principal outstanding at the date of forgiveness is still $2.5 million. Based on an analysis of your child’s company and the current interest rate environment as of the date of forgiveness, it is estimated that the fair market interest that would be charged on this note is 14%.  

As a result, the fair market value of the note as of the date of forgiveness is estimated to be approximately $512,000, about 20% of the original loan amount. 

It’s important to remember that forgiving loans earlier provides a better discount. A longer remaining life on a loan means a larger discount and larger tax savings. 

In other words, if you collected the note through maturity, you would have received all the remaining interest payments (totaling $524,000) plus the entire balance of the note ($2.5 million). By forgiving the note to your child at the end of 2024, you are using up $512,000 of your lifetime exclusion in exchange for reducing your taxable estate by $3.024 million ($2.5 million loan plus $524,000 of remaining interest). If your lifetime gifts and estate at death are more than the basic exclusion amount, you will save just over $1 million (40% x $3.024 million less $512,000 gift) in overall estate tax by forgiving the loan to your child’s startup company.  

Note: depending on the state a taxpayer resides in, there may be additional state-level estate tax liability. 

Establishing a Plan 

It is important to mention that the notes need to be legitimate, otherwise you face increased risk of scrutiny by the IRS. A formal structure should be established through a signed loan agreement with a defined payment schedule. Interest income should be reported by the lender and timely payments should be made. In addition, the IRS requires adequate disclosure for all items reported on gift tax returns. A formal valuation of the loan should be completed and attached to the gift tax return to substantiate the value and meet all requirements. 

If you hold a personal loan that you are considering forgiving, think about taking advantage of the current interest rate environment by gifting the loan at a discount and saving on estate tax. Understanding the strategies available to you and knowing when to act can help you give your loved ones security and prosperity in both the present and future. Contact us below to discuss your situation and opportunities to use the increased lifetime exclusion before it sunsets. 

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