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What to consider before lending money to family and friends

 

When your best friend views your nest egg as a source of start-up funds for his latest business venture, or your nephew hits you up for a car loan, your first impulse may be to reach into your bank account to help. But it's a fact that loans to family and friends often end up straining both finances and relationships. As Shakespeare said, "Loan oft loses both itself and friend." In other words, if you lend money to friends, you often don't get paid back, and the friendship itself may disintegrate.

 

It's best to consider a loan to someone you love as an "arm's length" transaction. If you're pondering such a loan, keep the following in mind:

 

* You can just say "no." It's your money, after all. Do you really want to raid an emergency fund or dip into your child's college account to finance a friend's business idea? Think like a bank. It's reasonable to ask tough questions about the person's bank accounts, potential sources of income, planned use of loan proceeds, and spending habits before extending credit.

 

* Consider a gift. If you're comfortable sharing your resources, you may want to provide a monetary gift with no strings attached. In many cases, this is the best solution because neither you nor your friend expect the money to be paid back. Unlike a loan, this type of arrangement can forestall misunderstandings and hurt feelings later on. Of course, you should not give money if doing so would unduly strain your own finances.

 

* Formalize loans. If you decide to lend more than a small amount to a friend or family member, it's generally best to draft a written agreement. This can be as simple as filling out a promissory note (available online or at office supply stores). Such forms spell out the basic terms of the loan -- amount, interest rate, payback period -- and provide some limited protection should you and the borrower end up in small claims court. Another recent innovation is the use of direct lending (also called social lending or peer-to-peer lending) websites to facilitate loans between family and friends. For a fee, such sites can prepare loan documentation, send payment reminders, issue regular reports, even facilitate electronic fund transfers. If the loan involves a significant amount of money, check with your attorney.

 

Remember: Many personal relationships have been damaged when loans go awry. So proceed with caution.

 

19 July 2012
Tax rules apply to family loans

Posted in tax

 There are many worthwhile reasons to lend money to a relative. For example, you may want to help a child or sibling continue their education or start their own business.

 

But lending money to relatives can have tax consequences. The IRS requires that a minimum rate of interest be charged on loans. If you do not charge at least the minimum rate, the IRS will still require you to pay tax on the difference between the interest you should have charged and what you actually charged. If these excess amounts become large, or if the loan is forgiven, there may also be gift tax implications.

 

There are some exceptions, though. Loans of up to $10,000 generally can be made at a lower (or zero) rate of interest, as long as the proceeds aren?t invested. Loans between $10,001 and $100,000 are exempt from the minimum interest requirement as well, as long as the borrower?s investment income is $1,000 or less. If the investment income exceeds $1,000, you?ll be taxed on the lesser of this income or the minimum IRS interest.

 

For the IRS to treat the transaction as a loan and not a gift subject to the gift tax rules, the transaction must look like a loan. The borrower should have the ability to repay the principal and interest. A contract should be prepared which specifies the loan amount, interest rate, the payment dates and amounts, any security or collateral, as well as late fees and steps to be taken if the borrower doesn?t pay. Have the document signed and dated by all the parties. For assistance, give us and your attorney a call.

Last Updated by Noel Dalmacio on 2012-07-19 10:44:00 AM