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Psst ... Can you spare some dough?

At first blush, lending money to a family member seems to be a relatively easy decision. After all, families should stick together.

But there are many considerations, including details of the loan itself, that can make it challenging.  If, for example, the loan is created in a less-than-business-like fashion, it could draw unwanted attention from the Internal Revenue Service.  And a problem with a repayment? That can send ripples throughout the family.

Finally, of course, are the issues of whether the relative has the available cash to lend and whether he is comfortable lending to a family member. These are just a few of the considerations that go into the decision of one relative lending money to another. Many of the same issues are involved with co-signing for a loan with a relative. In both cases, one relative puts his own money -- and credit report -- at risk for another one.

Some family members may decide it's easier or better for the loan seeker to go to a lending institution such as a bank, thrift or credit union. Others may choose to make a gift to help the relative, but let a lending institution make the loan for the balance of the required amount.

If, however, the parents, grandparents or other relatives decide to pull out their checkbook, use a written contract or promissory note including such relevant details as:

  • amount borrowed
  • interest rate
  • life of loan
  • repayment schedule, and the date each payment is due

Monetary gifts should be recorded as well.

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Tip: Consult your tax adviser or attorney before making any significant loan or monetary gifts.  A family loan should be structured like any other standard loan to avoid scrutiny by the IRS and to avoid adverse gift and income tax consequences.  The tax authorities have an interest in transactions between family members--including those between parents and children.

Take a common example of parents wishing to help their son and daughter-in-law put together the down payment for a home.  If parents are giving the money, they should create a gift letter, which is a notarized document stating that the recipient does not have to repay the money and that the gift is not considered a debt of the recipient.

Each parent can give up to $10,000 a year per individual recipient without incurring a federal gift tax or using up his or her $600,000 lifetime exemption for federal gift and estate tax purposes. If Mom and Dad each give $10,000 to their son and the same amount to his wife, they can give $40,000 tax-free to the couple for the year.

Those families that are able to make even larger gifts, say $60,000, should consider giving the maximum yearly amount at the end of one year and the remaining amount at the beginning of the next year. For example, $40,000 could be given in December, and $20,000 given in January.

Then, there's the issue of loans.

If a parent loans more than $10,000 a year to a family member, the parent could be required by the IRS to show proof that the money was a loan. Otherwise, the loan could be considered a gift.

Low interest loans are another option for a parent.

But the interest rate on the loan must be at least as high as the "applicable federal rate" that is set and published monthly by the Internal Revenue Service in the Internal Revenue Bulletin -- contact the IRS at (800) 829-1040 for further information. If the interest rate on the loan is less than the applicable federal rate, the parent will be subject to the "imputed interest" rule for income tax purposes.

Under this rule, the parent will annually be deemed to have received taxable interest on the loan computed using the applicable federal rate, whether or not any interest is paid by the borrower. Due to the complicated tax rules in this area, have your tax adviser or attorney prepare the loan documents when making loans to family members.

Posted: May 19, 1998

 

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