Instead of paying off a high-interest-rate note to a family member with cash or with non-cash assets that might result in the recognition of gain, it appears possible for a borrower to issue a new note at the lower current AFR and substitute it for the old note, without adverse tax consequences. Intrafamilial arrangements labeled as loans have long invited special scrutiny from the IRS. In some cases, the Service has successfully established that the arrangement was not a loan but another type of transfer, such as a gift. In the wake of several IRS victories in cases where somewhat ‘informal’ financial arrangements between family members were held not to be loans, many advisors to individual taxpayers counsel that when a child borrows money from a parent, for example, the loan should be documented, interest-bearing, secured, and repaid (at least in part), if the transaction is to be free of unexpected and in some cases adverse tax consequences. In any event, even where the financial arrangement is respected as a loan, tax effects, such as generation of interest income taxable to the lender or the trigger of a gift tax on either the borrower or the lender, may arise. Some of these consequences will be discussed below along with a detailed look at some effects of substituting a new note at the ‘applicable federal rate’ (AFR) that is lower than the interest rate payable on the old note.
Bridget J. Crawford, Jonathan G. Blattmachr & Elisabeth O. Madden, How Low Can You Go? Some Consequences of Substituting a Lower AFR Note for a Higher AFR Note, 109 J. Tax’n 22 (2008), http://digitalcommons.pace.edu/lawfaculty/570/.