Homeownership has become more difficult to attain. For Muslim families committed to avoiding riba (interest), the challenge is even greater. While many parents consider intra-family loans to support the next generation, traditional loans involve interest, making them incompatible with Islamic finance. Fortunately, there are alternative structures that achieve similar goals, allowing you to help your child buy a home in a way that is both IRS-compliant and Shariah-compliant.
To structure an intra-family loan that is both IRS-compliant and Shariah-compliant, you must carefully balance two systems.
- IRS requirements: The loan must be documented, including interest at or above the Applicable Federal Rate (AFR), and have a clear repayment plan.
- Shariah principles: The transaction must avoid riba (interest) and instead rely on ethical, asset-backed structures that generate profit, not interest.
Here are three structured options that mimic the financial support of a loan but are not technically loans, while remaining compliant with Islamic principles and acceptable under U.S. tax law.
1. Murabaha (Cost-Plus Financing)
- How it works: The parent (or a trust or entity they control) purchases the home or desired asset and then sells it to the child at a markup, with payment made in installments.
- The markup replaces interest, and since it’s disclosed upfront as part of the sale, it’s considered permissible in Islamic finance.
- IRS treatment: If the arrangement is documented with a contract showing a set purchase price and a payment schedule, the IRS usually considers this a valid sale with installment payments. There may be capital gains or income recognition implications depending on the structure; therefore, you should consult a tax advisor for guidance.
2. Ijara (Lease-to-Own Agreement)
- How it works: The parent or a trust/LLC purchases the property and leases it to the child, who pays monthly rent and gradually gains ownership through a side agreement or at the end of the lease term.
- Payments can include both rent and a portion toward equity accumulation.
- IRS treatment: The IRS may treat this as either a lease or an installment sale, depending on how it’s structured. If the contract indicates a fair market rent and a future purchase price, it can meet IRS expectations, especially if the arrangement resembles a legitimate business lease.
3. Profit-Sharing (Musharakah Mutanaqisah) – Diminishing Partnership
- How it works: Parent and child buy the home together. Over time, the child buys out the parent’s share while also paying “rent” for the parent’s ownership portion.
- This is common in Islamic home financing.
- IRS treatment: Treated as a joint ownership arrangement with a buy-sell agreement. The parent’s income from “rent” is taxable, and capital gains may apply when their ownership portion is sold. Use this guide to help you understand what you need to know when renting property.
Making it Official: What the IRS Requires.
Once you’ve chosen a Shariah-compliant structure for your transaction, it’s crucial to document the arrangement to meet IRS (and Shariah) requirements properly. This includes drafting a formal agreement that clearly specifies key details, such as:
- The purchase or lease price of the house
- Payment terms and duration
- Any collateral or security provisions
- How ownership will transfer, whether gradually or all at once
Additionally, if the arrangement generates income, such as rent or a profit markup, the parent may be required to report it and issue the appropriate tax forms, including Form 1099. We strongly recommend consulting with your tax advisor.
A word of caution: with a traditional intra-family loan, these loans must include an Applicable Federal Rate (AFR), which is the minimum interest rate set by the IRS for loans. It is based on U.S. Treasury yields and is the lowest interest rate you must charge on a loan for it to be considered a legitimate loan rather than a gift.
However, if you structure your transaction as a Murabaha, Ijara, or Musharakah Mutanaqisah, the AFR requirement does not apply because these are not classified as loans. Instead, they are structured as a sale (Murabaha), a lease (Ijara), or a co-ownership buyout (Musharakah). In each case, you’re not lending money — you’re engaging in an asset-backed transaction. The IRS treats these differently from traditional loans, which is why interest isn’t required.
Ready to Help Your Child Without Compromising Your Islamic Values?
Structuring a Shariah-compliant real estate transaction requires careful planning, but you don’t have to do it alone. Our team at Azzad can help guide you through the process so that it aligns with your Islamic principles and helps you avoid potential tax pitfalls.
