Bridge loans between individuals: how to document one

A bridge loan between individuals is a short-term loan that covers a gap until a specific payout arrives, most often the sale of the borrower's current home. You document it with a promissory note that names the payout event, sets a firm outside maturity date, states the interest, and says what happens if the sale never closes.

Picture your daughter under contract on a new house while her old one is still listed. She needs $60,000 for the down payment now and expects at least that much in equity when the old house sells. You can cover the gap. The paperwork is what keeps a kind favor from turning into an open-ended IOU that nobody wants to bring up at dinner.

Setting the maturity and the payments

A demand note lets you call the money whenever you choose. That gives you flexibility, but it gives the borrower no date to plan around, and the Internal Revenue Service (IRS) applies different below-market loan rules to demand loans and term loans. For most bridges, a fixed maturity works better. Tie repayment to the closing of the sale, and add an outside date so the loan cannot drift if the sale stalls.

Most bridges are interest-only. The borrower pays interest each month and repays all of the principal in one payment at closing. At 6 percent, interest on $60,000 is $300 a month, and a partial month accrues at $9.86 per day on a 365-day year. Our post on interest-only promissory notes covers that structure in more depth.

Suppose the sale closes four months and 18 days after you fund the loan. Here is what your daughter pays:

Choose the outside date with care. A date that is too close forces a default while the house is still drawing offers. A date that is too far turns the bridge into a long-term loan nobody planned. Many families start from the listing agent's estimate of time to sell, then add a cushion of several months for a buyer's financing to fall apart and the house to go back on the market. Write the reasoning down for yourself, even though it does not belong in the note.

A few more terms belong in a bridge note. Name the property by street address so there is no doubt which sale triggers repayment. Let the borrower prepay at any time without a penalty, since the loan exists to be repaid at closing. Say where payments go and how, and keep every transfer in a form you can trace later, such as a check or a bank wire rather than cash.

Because the loan rides on a house sale, consider securing it with a secured promissory note. Real estate collateral calls for a mortgage or deed of trust recorded in the county where the house sits. Article 9 of the Uniform Commercial Code does not handle that; Minnesota's version, for example, excludes "the creation or transfer of an interest in or lien on real property" apart from narrow exceptions. Personal property such as a car is the opposite case. There, a financing statement "must be filed to perfect all security interests," subject to listed exceptions. Our guide to securing a note with collateral and a UCC filing walks through that process. A recorded lien on the old house also puts your loan in front of the title company, which can pay you directly from the sale proceeds.

If the sale falls through

Decide this before you lend, while everyone is still optimistic. The note can make the full balance due on the outside date, or it can convert the loan into monthly installments. Conversion is usually gentler within a family. At 6 percent, $60,000 spread over 24 months comes to $2,659.24 a month, so make sure the borrower can actually afford that figure before you write it in. Here is a sample clause that ties everything together:

Repayment on sale. Borrower shall repay all unpaid principal and accrued interest on the earlier of (a) the closing of the sale of the property at [address], or (b) [outside date] (the "Maturity Date"). Borrower directs the closing agent to pay this Note in full from the sale proceeds at closing. Until then, Borrower shall pay interest only at 6 percent per year on the first day of each month, and interest for any partial month accrues at $9.86 per day. If the sale has not closed by the Maturity Date, the unpaid principal shall be repaid in 24 equal monthly installments of $2,659.24, beginning one month after the Maturity Date.

Family bridges raise one more question: taxes. If you charge no interest, or less than the applicable federal rate, the below-market loan rules in section 7872 of the Internal Revenue Code can apply. IRS Publication 550 explains that for gift loans between individuals totaling $100,000 or less, the forgone interest the lender reports is limited to the borrower's net investment income, and if that income is $1,000 or less, "it is treated as zero." An interest-free $60,000 bridge to a child whose only investment income is $400 of bank interest would generally produce no imputed interest, unless avoiding tax is one of the main purposes.

Charging at least the applicable federal rate avoids the question entirely, and our explainer on the IRS minimum interest rate for family loans shows where to find it. Whatever you choose, sign the note before any money moves, keep proof of the transfer, and put the outside date on your calendar.

Sources

• IRS Publication 550, Investment Income and Expenses (Below-Market Loans)
• Minnesota Statutes 336.9-109, Scope of Article 9
• Minnesota Statutes 336.9-310, When filing required to perfect security interest