What you should Consider When Lending Money to a Family Member
What you should Consider When Lending Money to a Family Member
Anyone considering a loan with a family member should discuss their specific situation with a trusted financial advisor or tax planner there is always important factors to consider when lending money to a family member:
1. Enter the loan relationship for the Right Reasons. Loans to irresponsible family members, or those in financial trouble, are usually bad investments and can only lead to trouble
Find out why a borrower is seeking a loan in the first place. Why from a relative? Have they been turned down by the banks? Are they taking care of their existing debt obligations?
Are they capable of repaying the loan Do they have a specific reason to borrow the money such as buying a house or a car and need help with a down payment? Have they borrowed money from a family member before? How did that loan make out?
How does the borrower intend to repay the loan? Are they employed? Do they have a budget? Can they commit to a repayment schedule and repay the loan by a specific date?
Where is the lender's money coming from? Do they have an emergency fund or savings account? It's never a good idea to lend retirement savings. Likewise, lenders should never take out a loan on a desperate family member's behalf. A lender should absolutely not risk their credit and good name on a questionable situation.
Can the lender afford to lose the money? Will the lender's retirement plans be significantly altered from if the money was invested elsewhere? If the loan goes bad, how will it affect the lender's relationship with the borrower?
2. Make sure to document the Loan. While it may seem awkward, overly formal, or maybe even insulting to suggest documenting a loan with a loved one, without a legally binding promissory note, the IRS could reasonably argue that there was never a loan in the first place but a taxable gift.
3. Determine the correct Interest Rate.
Each month, the IRS publishes a set of base interest rates called the "Applicable Federal Rates" (AFRs). These interest rates are determined by a variety of economic factors and are used for various purposes under the Internal Revenue Code including the calculation of imputed interest on below market loans between family members.
When possible, try to structure a win-win interest rate; the lender receives a rate lower than they may otherwise receive from a bank, while the lender receives a better return than from a savings account, money-market, or CD. Use of the AFR typically achieves this objective. Be advised, if considering higher rates upward of 6% the loan may be in violation of state specific usury limits, and therefore be legally unenforceable.
4. Agree Upon a Repayment Plan, and Again, Document the Loan. Use a third party such as www.one2onelending.com to help you document the loan. Set crystal clear expectations with a borrower from the start. Agree upon a realistic repayment schedule that meets everyone's financial needs. Intra-family loans with clear, monthly, repayment plans are for more successful than loans with lump-sum payments due sometime in the distant future.
Documentation is crucial; not only to satisfy the IRS, but to ensure the lender completely understands their responsibilities. A promissory note is a legally binding debt instrument. Again One2One Lending has an inexpensive way to create a Promissory Note.
Make it clear the borrower is engaging in a business transaction not a friendly arrangement.
A poorly documented loan that the IRS considers a gift could have significant effects on the lender's life-time gift and estate tax exemptions. If the borrower is unable to repay the loan and the lender wishes to deduct the loss from their income taxes, a promissory note that shows that the loan was legitimate could be extremely important.
Proper loan documentation of a friends and family loan can also help avoid serious legal disputes with other family members (especially between siblings) or estate and repayment complications following an unexpected divorce or untimely death.
If a family loan is being used to specifically help purchase or refinance a home, in addition to properly documenting the loan with a legally binding promissory note, the borrower and lender should consider the advantages of securing the loan through a properly registered Mortgage or Deed of Trust.
Like a bank mortgage, a Family Mortgage is legally registered with the appropriate government authority and allows a borrower to legally deduct their annual interest payments from their federal tax return. Likewise, the lender has a secure lien on the property, both insuring their investment while protecting their estate and other family members from federal tax complications.
5. Again, use a Third Party to help document your loan. While hiring an attorney to draft a legally binding promissory is always an option, there are several, reputable, reliable, and affordable online services that exclusively focus on helping families properly manage loans with their loved ones. Having a neutral third party involved it the debt collection process can help ensure the borrower takes the loan all the more seriously. The Resource Center at One2One Lending can help answer all of your related questions.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.
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