Breaking up is hard to do and apparently that is the case with Brad Pitt and Angelina Jolie. In the two years since their split, a heavy drama has played out in the press. Amidst their recent public skirmishes an interesting fact appeared: Pitt had made a loan to Jolie for $8 million dollars to buy a home after their separation.
In fact, Jolie’s attorney, Samantha Bley DeJean told People magazine in regard to the loan that, ‘’Brad was asked to assist in the expense of a new home for Angelina [and their six children] but instead he loaned Angelina money, for which he is charging her interest on a payment plan.’’
While it might seem that Pitt is being cold to his soon to be ex and their six children, the loan was actually a clever financial planning strategy. In Pitt’s case, the use of an intra family loan is helpful when navigating a divorce proceeding. Since there is not yet a divorce settlement, he needs to be careful about making any unintended gifts to his soon to be ex-wife.
“A properly structured loan can be a powerful tool to maintain control over the use of the proceeds. It may also be a way to fund a business transaction or a marital dissolution,” says Glenn Christofides, a New York and New Jersey tax and estate attorney who is not advising Pitt or Jolie.
In Pitt’s case, helping Jolie buy a house through the use of a loan, maintains clarity during a divorce proceeding. In the world of tax planning, intra family or ‘below market’ loans are fairly common to help family members buy a home or to provide liquidity in estate planning. But before going down the path, it is key to understand all the risks involved.
The Fundamentals of Below Market Loans
Regardless of the reason for a below market loan, it must always be based on good faith. In Pitt’s case, he is merely trying to keep his family in a home appropriate for their situation.
When structuring the loan, basic loan requirements must be met to ensure the loan is not seen as a gift. The IRS will look at various factors including whether there is a signed written loan agreement with a fixed repayment schedule and a stated interest rate. Further, the loan holder must report the payments on their tax return. In the event the loan was secured against real property, the payor may even be able to deduct it as mortgage interest up to the legal limit.
The emphasis on correct documentation and structure is important and should be done in coordination with an attorney and CPA. As Christofides notes, “If these aspects of the transaction are not properly addressed, an intended lender can find himself with a non-collectable debt.”
Further, setting an interest rate is not a random decision. “Below market in the tax context means an interest rate below a statutory rate called the Applicable Federal Rate (AFR). The AFR has historically been lower than commercial rates (currently less than 3%). It’s easy to have a loan that is “below market’ in the common sense but still not below market in the legal sense,” explains Christofides.
The AFR rates, released monthly by the IRS, are dependent upon whether the loan is short term (3 years or less), mid-term (3 to 9 years) or long term (more than 9 years).
In the Pitt-Jolie situation, it appears these requirements have easily been met as Pitt is charging Jolie interest and requiring a payment plan. While the loan amount is large, given the fact that it is likely a short-term loan, Pitt probably used a short term AFR rate. And if it was secured against the home, Jolie may be able to deduct a portion of the interest.
For high net worth individuals like Pitt and Jolie, a loan structured incorrectly can hurt them. As Christofides points out, “If the parties aren’t aware of the issues and structure a loan with a rate below the AFR, there can be unintended consequences for the lender. These include imputed income and gifts for Federal tax purposes.”
A Useful Tool for Many
While Pitt and Jolie’s divorce may not be proceeding smoothly, their financial planning around it is being done correctly as they navigate settlement issues. The loan will likely be addressed in the final divorce decree.
As for the rest of us, a below market loan between family members might be something we consider not only in divorce situations. For instance, in some of the most highly inflated real estate markets in the United States, parents and grandparents might use below market loans to help their children get into a market that otherwise could be challenging. Or they can be used within a family to provide student loan help versus using private lenders.
Regardless, the intra family loan is a valuable technique for helping family members financially, provided you have a knowledgeable attorney and CPA to properly take you through the process.