Loans to Family Members and Divorce

By Ed Kerns, CDFA On 08/11/2020

Going through a divorce is never pleasant and doing so during a pandemic only adds to this challenging time. But, even as COVID-19 continues to impact people and economies around the globe, the market environment arising from this crisis does offer some opportunities to explore for those facing the financial burden of divorce.

With interest rates being so low, an intra-family loan (or unrelated person for that matter) may be a good option to consider. When making a loan to another person for more than $10,000, the IRS requires that an adequate interest rate be charged on the loan. Interest must be charged at least equal to AFRs (Applicable Federal Rates). The August 2020 AFR rates are

  • short-term (< 3yrs): 0.17% 
  • mid-term (3-9yrs): 0.99% 
  • long-term (>9yrs): 1.44% 

These rates are tied to the bond market and are revised monthly, so they are subject to change. Setting up the loan with specific terms and establishing the date for repayment or specific installment dates will allow you to lock in the AFR for the loan’s duration. 

While setting up your loan in a formal manner to comply with IRS requirements is certainly a good idea, putting the loan terms in writing can also have other benefits during a divorce. 

But what if there was an intra-family loan during the marriage? Years earlier, for instance, the parents of one spouse gave the married couple a sum of money. In the event of a divorce, whether this transaction is deemed a gift or a loan can have important implications as assets and liabilities are being allocated. 

Assume, for example, one spouse says the $20,000 received by a family member was a loan and wants it to be treated as marital debt. While the other spouse says it was a gift, not to be repaid. If the first spouse is allocated the $20,000 loan in their column, they will receive $20,000 more in assets to offset that liability. If it’s treated as a gift, then they receive no additional funds to repay the money. 

In a situation like this, it may be possible to show that repayment efforts had been made over the years, which would be a good indication that this was intended to be a loan. But, having a formal agreement, and preferably one created at the time the money is transferred is likely a better way to prove the existence of the loan. 

So, whether you’re looking to get a loan from a family member as a result of getting divorced or if you’ve received funds during your marriage that was intended to be a loan, document these decisions and put the terms in writing.

Tagged with: afr, divorce, finance, marital debt