THRIVING IN A HIGH-RATE ECONOMY

The First National Bank Of Grandma
WITH INTEREST RATES RISING, MORE PEOPLE ARE BORROWING FROM THEIR PARENTS-OR GRANDPARENTSTO GET A FINANCIAL BOOST NOW. DOING SO BRINGS FUTURE BENEFITS, TOO.
KELLY PHILLIPS ERB
Ever since the Federal Reserve started fighting inflation by driving up interest rates, banks’ prime rate, on which so much adjustable and short-term loan pricing hinges, has climbed from 3.5% in March 2022 to 8.5% now. That has pushed unsecured personal loans above 12% and average credit card interest above 21%. Thirty-year fixed mortgage rates have been flirting with 8%, up from under 3% in 2021. Those unpleasant numbers, combined with favorable tax rules governing intrafamily loans, make borrowing from the Bank of Grandma a savvy option for many well-off families, particularly if the older generation is sitting on gobs of cash.
In addition to a healthy family dynamic, the keys to making these loans work are planning, paperwork and, most importantly, insisting that Grandma charge the current “applicable federal rate” (AFR)—the minimum fixed interest a private lender must levy on a new loan to avoid unwanted tax complications. In December, the AFR was 5.26% a year for loans of three years or less; 4.82% for midterm loans of up to nine years; and 5.03% for longer-term loans such as 15- and 30-year mortgages. They represent “a really excellent alternative to prime rates,” says Laura Mandel, chief fiduciary officer at the Northern Trust Company in Chicago.
What happens if you don’t charge the AFR minimum? The IRS could argue that you’re making a disguised gift to the borrower. Indeed, you might want to use a loan to transfer money over time through loan forgiveness, but you don’t want to do it inadvertently.
In August, Justin Miller, national director of wealth planning at Evercore, the big New York City investment banking firm, helped a retired couple extend a $2 million interest-only mortgage to their 30-something son and daughterin-law for the purchase of a home in San Francisco—conveniently located for seeing their two grandchildren. They hired a lawyer to draft the proper loan documents, with a mortgage recorded against the property. The young couple can deduct the interest paid on the first $750,000 of borrowing, the same as if they had used a traditional bank. All the interest paid is taxable to the retirees and yields a return comparable to what they might get in a money market fund. “The children now live in a beautiful $2 million home, and any appreciation will happen outside of the parents’ estate,” Miller says.
Meanwhile, the retirees, cash-rich after the recent sale of a business and receipt of an inheritance, are also using their annual gift exclusion—the amount anyone can give anyone else each year with no gift tax consequences—to further help the young family. (For 2024, the exclusion is $18,000, or $36,000 if you split gifts with your spouse.)
Why not simply make a big gift now so the couple could buy the house with a smaller commercial mortgage? The retirees, still in their 60s and committed to charitable giving, aren’t ready to do any large wealth transfers yet. And, Miller says, there’s this: Heaven forbid, should the young couple’s marriage go south, any gifted money invested in their jointly owned house would be community property in California, to be split equally between them. With a loan, if divorce or other circumstances means the house must be sold, the retirees get their $2 million back first from the proceeds of the sale.
Taking collateral and registering a security interest is essential for a mortgage, but it’s also helpful for smaller loans, says David Oh, head of tax and estate planning at Arta Finance, a Mountain View, California–based fintech serving accredited investors with a minimum liquid net worth of $1 million. Even small loans should be documented with a signed promissory note that at minimum spells out the interest rate, repayment terms and what will happen in the event of a default. That should keep both the IRS and misunderstandings at bay. (You can complete a promissory note for a small loan using a form on the web, but get a lawyer’s help for amounts you’re not prepared to lose.) Some families even use professional loan servicing firms to bypass awkward in-person financial exchanges.
As for turning loans into gifts, the annual gift exclusion can be used to forgive both interest and principal over time. Indrika Arnold, a senior wealth advisor at the Colony Group in Concord, New Hampshire, encourages some clients to forgive even bigger loans as a way to make use of their lifetime exemption from gift and estate taxes—$13.6 million per person or $27.2 million per married couple in 2024—before it drops in a couple years. Unless Congress decides otherwise, it will fall by about half in 2026, but gifts that have already been made will be safe. Loans can also be forgiven after death, typically by a provision in the will, but be aware that a loan that remains outstanding at the death of the lender is considered an asset adding to the value of the estate, cautions Jim Bertles, an estate lawyer and managing director of AlTi Tiedemann Global in Palm Beach, Florida. If the plan is to forgive the loan in its entirety, the lender should consider including equalization terms in the will—that is, if one child’s note is forgiven, payments are made to any other children to ensure that the estate is distributed equally (assuming that’s the goal). That strategy could backfire if you’re not careful, given that preplanning for forgiveness could signal to the IRS that you never intended it to be a legitimate loan. The way around this? Simply leave your kids enough money to pay off the loan.
There are other, more advanced ways to make intrafamily loans work for a wealth transfer. One of the most popular is combining a loan with what’s known as an intentionally defective grantor trust, or IDGT, Bertles says. During their lifetime, the grantor places appreciating assets in an IDGT for heirs, freezing the value of those assets for estate and gift tax purposes. (Crafting it as intentionally defective means any income in the trust will be taxed annually to the grantor, not the trust, turning the income tax paid into an additional gift tax–free transfer to heirs.)
Here’s where the loans come in. Rather than fund the IDGT with a gift, the grantor can make a loan to the trust, with the money then used to make investments that will (ideally) appreciate and throw off income, which is used to repay the note. The key, Bertles says, is that the return on the investment must be more than the interest rate. That way, the spread will pass transfer tax–free to the trust. In the end, the grantor’s taxable estate is lower than it would have been without the IDGT and the loan, making it a win-win for the family.
 
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High Rates, Higher Returns
BUSINESS DEVELOPMENT COMPANIES ARE OFFERING JUICY DOUBLE-DIGIT YIELDS, PLUS BONUSES, TO INCOME-HUNGRY INVESTORS. IT'S TEMPTING, BUT BEWARE OF LONG-TERM RISK.
HANK TUCKER 
With interest rates at heights not seen in nearly two decades and traditional lenders still shell-shocked from this past spring's bank runs, private credit, or nonbank direct lending, is booming on Wall Street.
Yield-chasing institutions have poured into the sector, which now amounts to $1.5 trillion globally. But pension funds, endowments and other big players need not be the only investors feasting on high yields.
A great way retail investors can partake in private credit's spoils is by buying the stocks of business development companies (BDCs). These outfits are required to lend to small or medium-sized businesses, which usually don't have access to public debt markets. There are more than 130 BDCs, according to the Small Business Investor Alliance. The largest is the $48 billion Blackstone Private Credit Fund (BCRED), which yields about 10% currently. That fund is sold exclusively through financial advisors and limits redemptions at book value to once per quarter. But Blackstone and every other major private equity firm-including KKR and Apollo-plus credit specialists like Ares Management and Blue Owl also offer publicly traded BDCs with daily liquidity. These funds are currently offering annualized yields from about 6% to more than 16%.
Most BDCs are required to pay out 90% of their earnings to investors as dividends, and the majority of loans in a typical BDC’s portfolio are floating-rate, giving them a measure of protection against interest rate swings. Many BDCs, such as Blue Owl Capital (OBDC), which has $12.9 billion in assets, have raised their dividends this year and are also throwing in supplemental or “bonus” dividends, promising to pay out 50% of any excess earnings beyond the base amount. The bonuses reward investors during good times but also let BDCs avoid dividend cuts later when interest rates retreat. OBDC’s base dividend for the third quarter was raised to 35 cents per share and came with an 8-cent bonus, implying an annualized dividend of $1.72 or a 12% yield at its current price of $14.38. OBDC trades at a 7% discount to its book or net asset value. “You’re earning equity-like returns in a defensive portfolio of loans,” crows Craig Packer, copresident of Blue Owl and CEO of OBDC, which has 83% of its portfolio in senior debt, the type that gets paid early in a bankruptcy. Blue Owl, which went public in 2019, had a 12.7% return on equity in the third quarter. It specializes in lending to software companies and noncyclical sec...