What’s wrong with loaning money to family and friends?

Inez Bowie | May 17th, 2010

Dear Cousin Lauren is in a tough spot and she asked you for money. Again. Granted, she’s family and you want to help, but maybe she hasn’t made the best financial decisions in the past. What should you do?

It’s tempting to loan money to a friend or family member when times are tough. But whether Cousin Lauren asks you to float some cash “just this once,” or needs ongoing help that may impact your comprehensive estate plan, consider the following before you commit to an intra-family loan.

Deciding to help

Some advisors believe you shouldn’t loan money to family and friends. You will probably never see it again, which could damage the relationship and even your own personal finances. Not to mention that this quick fix doesn’t teach Cousin Lauren to manage her own money better. Instead, teach her how to make smart choices so she doesn’t end up in the same spot a few months down the road.

Putting it in writing

Without documentation, the IRS may consider the “loan” a gift and deny the deduction and loss if Cousin Lauren can’t pay you back. A signed statement or promissory note documents your loss as a non-business bad debt, which could reduce any capital gain. It should include:

  • the interest rate, if any
  • a schedule showing dates and amounts for all interest and principal payments
  • security or collateral for the loan, if any

Document when you will be repaid and report the interest received as income on each tax return. This shows the transaction is a loan and documents the deductible loss if you never see the money again.

Charging interest

Most intra-family loans are below-market loans. If they have interest at all, it’s usually at a rate below the applicable federal rate (AFR). A loan at or above the AFR means interest income every year for you, but Cousin Lauren may not be able to deduct the interest. It depends on the loan’s use.

With today’s AFRs so low, you can charge a lower rate without creating tax complications. For a short-term loan repaid over a period of three years or less, the AFR in May was 0.79 percent. The AFR for mid-term loans (between three and nine years) was 2.87 percent and 4.47 percent for long-term loans lasting more than nine years.

When you make a below-market loan, tax law considers it an imputed (imaginary) gift to the borrower. The imaginary gift equals the difference between the AFR interest you “should have” charged and the interest you actually charged. The borrower must pay these phantom dollars back to you as imputed interest.

Paying taxes

Although this is all fictional, you must still report the imputed interest as taxable income on your tax return and pay tax on it. When your imputed gift to the borrower exceeds $13,000 for the year, it can also have adverse gift and estate tax consequences. Be sure to talk to your advisor first, though – this situation can get sticky.

There are potential tax complications to loaning some of your hard-earned money to Cousin Lauren. With careful thought, planning and documentation, you can avoid these potential pitfalls.

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