The Intrafamily Loan as an Estate Freeze

The IRC §7872 machinery earlier in this chapter treats below-market lending as a compliance problem. Turn it around: charging exactly the AFR is not a defensive minimum, it is the entire strategy. A loan at the AFR is a completed, non-gift transaction — no gift tax, no exemption consumed, no Form 709 — and every dollar the borrower earns above that rate belongs to the borrower, permanently outside your estate.

The value transferred is the compounded spread:

Lend a child $1,000,000 on a nine-year note at a 4% mid-term AFR, and suppose they invest it at 8%. At maturity the portfolio is worth $1,999,005 and the note plus accrued interest is $1,423,312. The difference — $575,693 — has moved to the next generation having consumed none of your $15 million exemption and triggered no gift tax at any point. You did not give anything away; you sold the use of money at a legislated price.

Four things govern whether it survives:

It must be a real loan

Written note, stated rate at or above the applicable AFR for the term, a fixed maturity, and — the one families skip — payments actually made and actually deposited. A note nobody services is a gift with extra paperwork, and the IRS recharacterizes it as one. Do not plan to forgive the balance in annual-exclusion slices; a pre-arranged pattern of forgiveness is evidence the loan was never intended, which retroactively makes the whole principal a gift in year one.

The spread is the entire product

If the borrower earns less than the AFR, you have transferred nothing and merely created a taxable interest stream for yourself. The technique is a bet that the borrower’s assets outperform a Treasury-derived rate — which is why it is most powerful when AFRs are low and least attractive when they are high. Lock long-term AFRs when they are cheap; that is the timing decision.

You are taxed on interest you may never want

The AFR interest is ordinary income to you every year, at your top rate, in the state you live in. The freeze works on the estate-tax axis while costing you on the income-tax axis — which is precisely why the trust version dominates for large transfers, since a grantor trust’s income is already yours and the note interest is ignored (section “Intentionally Defective Grantor Trusts (IDGTs)”).

It dies with the plan if you die holding the note

The unpaid note is an asset of your estate at its fair value. The freeze locks the growth out, not the principal.