Gift Tax Effects of Substituting a Lower AFR Note for a Higher AFR Note

6 Pages Posted: 1 Jun 2008 Last revised: 5 Jun 2008

See all articles by Jonathan G. Blattmachr

Jonathan G. Blattmachr

Milbank, Tweed, Hadley & McCloy LLP

Bridget J. Crawford

Pace University School of Law

Elisabeth O. Madden

affiliation not provided to SSRN

Abstract

This article explores the gift tax consequences of an exchange of promissory notes between family members when interest rates have dropped from when the original or old note was issue to the present time when the new note is issued. More specifically, the scenario contemplated involves two events. At the first, which is T=0, a parent loans money to a child and the loan is evidenced by a promissory note (old note) which provides for adequate interest (i.e., interest at a rate equal or greater than the Applicable Federal Rate or AFR that set by the Treasury Department) when it is issued by the child. Under section 7872 of the Internal Revenue Code of 1986 as amended (Code), the value of this note at T=0 is its face amount, as it bears adequate (AFR) interest. However, Code section 7872 does not determine that note's value at a later time, T=5, when the interest rates have gone down (or even if they have gone up or remained the same). At that time, Treas. Reg. ยง 25.2512-4 generally provides that the value of the old note is presumed to be its face value. Thus, if the old note is exchanged for a new note which provides for adequate interest (new note) and so would also be valued at face under section 7872, there should be no adverse gift tax consequences, as the notes exchanged have equal values: the old note likely will be valued at its face amount and a new note bearing current AFR will be worth its face amount. Hence, each party will receive back in money or money's worth an asset having a value the same as the one transferred. And when parties make such an equal worth exchange, there can be no gift for Federal gift tax purposes.

Keywords: gift tax, promissory note, promissory, notes, substitute, substitution, applicable federal rate, AFR, family, loan, intrafamily loan

JEL Classification: K34, K39

Suggested Citation

Blattmachr, Jonathan G. and Crawford, Bridget J. and Madden, Elisabeth O., Gift Tax Effects of Substituting a Lower AFR Note for a Higher AFR Note. Available at SSRN: https://ssrn.com/abstract=1139649 or http://dx.doi.org/10.2139/ssrn.1139649

Jonathan G. Blattmachr (Contact Author)

Milbank, Tweed, Hadley & McCloy LLP ( email )

1 Chase Manhattan Plaza
New York, NY 10005
United States
212-530-5066 (Phone)

Bridget J. Crawford

Pace University School of Law ( email )

78 North Broadway
White Plains, NY 10603
United States

Elisabeth O. Madden

affiliation not provided to SSRN ( email )

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