Q: I have a rental property valued at $265,000, the mortgage balance is $151,000 at 5.75%. I'm considering a loan to pay off this balance from my father's living trust account, which is in excess of $400,000. I am the sole heir and these funds are just sitting in money market accounts making .25%! I would set up documents for the loan for tax purposes pay the monthly interest to my father's account at 2.00% with a 5-year payback schedule. If my father passed, how would these funds $151,000 which would be outside the trust be viewed by the IRS? Is there an amount of money that can be outside the trust without being subject to probate or tax? - Walt, Sacramento, CA
A: A loan from a family member can benefit both parties. It is important that the loan documents are prepared properly to avoid potential problems including misunderstandings and possible adverse tax consequences. The interest rate on the loan must be set at or above the Applicable Federal Rate (AFR) in order to avoid gift tax issues. The IRS releases current AFRs each month, and the rate varies for short-, mid-, and long-term loans. The July 2012 AFR rate for a 5 year loan is .92% per year.
In your situation, your father could loan you funds from his living trust. The loan should be documented with a promissory note and, if your father wanted collateral, with a deed of trust on your rental property. So that the IRS won't characterize the loan as a gift, you will need to make timely payments to the trust, and your father should document his receipt of the payments. Your father would have to pay income tax on the interest that he receives. If your father died before the loan was fully repaid, the note would be distributed as part of the trust estate. If you are the only beneficiary, you would receive the note as part of your inheritance and the remaining debt would be extinguished.
In California, probate is not required for estates valued at less than $150,000. The $150,000 threshold amount excludes assets held in trust, payable-on-death accounts, transfer-on-death accounts, and certain other assets, but it would include an outstanding note. Thus, if the note is not held in the trust and your father died before the note was fully repaid, a probate would be required for your father's estate if the remaining unpaid balance of the note caused his probate estate to exceed the $150,000 limit.
I recommend that your father work with an experienced tax or estate planning attorney to prepare the proper documentation for this intra-family loan.