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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.
Posted in tax
With the recent economic downturn experienced by many
taxpayers, there is a tax concept that is very important: cancellation of debt.
You would think that the cancellation of debt by a credit card company or
mortgage company would be a good thing for the taxpayer. And it can be, but it
can also be considered taxable income by the IRS. Here is a quick review of
various debt cancellation situations.
* Consumer debt. If you have gone through some type
of credit ?workout? program on consumer debt, it?s likely that some of your
debt has been cancelled. If that is the case, be prepared to receive IRS Form
1099-C representing the amount of debt cancelled. The IRS considers that amount
taxable income to you, and they expect to see it reported on your tax return. The
exception is if you file for bankruptcy. With bankruptcy, generally the debt
cancelled is not taxable.
Even if you are not legally bankrupt, you might be
technically insolvent (where your liabilities exceed your assets). If this is
the case, you can exclude your debt cancellation income by reporting your
financial condition and filing IRS Form 982 with your tax return.
* Primary home. If your home is ?short? sold or foreclosed
and the lender receives less than the total amount of the outstanding loan, you
can also expect that amount of debt cancellation to be reported to you and the
IRS. But special rules allow you to exclude up to $2 million in cancellation
income in many circumstances. You will again need to complete IRS Form 982, but
the exclusion from taxable income brought about by the debt cancellation on
your primary residence is incredibly liberal. So make sure to take advantage of
these rules should they apply to you.
* Second home, rental property, investment property,
business property. The rules for debt cancellation on second homes, rental
property, and investment or business property can be extremely complicated.
Generally speaking, the new laws that cover debt cancellation don?t apply to
these properties, and the IRS considers any debt cancellation to be taxable
income. Nevertheless, given your cost of these properties, your financial
condition, and the amount of debt cancelled, it?s still possible to have this
debt cancellation income taxed at a preferred capital gains rate, or even considered
not taxable at all.
Be aware that many of the special debt cancellation
provisions are set to expire at the end of 2012. If you?re unsure as to how
debt cancellation affects you, contact our office to review your situation and
determine how much, if any, cancelled debt will be taxable income to you.
Last Updated by Noel Dalmacio on 2012-11-01 10:17:22 AM