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Lending money to loved ones

Ellen McGowan considers herself a generous person and a good mom, but that combination sometimes gets her into trouble. The Toronto-area mother estimates she's lent her 30-year-old son between $10,000 and $15,000 in recent years and hasn't seen a penny in return.

"It's a thousand here and a few thousand there, but it adds up," says McGowan, who asked that her real name not be used. She admits she has never formalized the loans, relying on her son's word that she'd be repaid. She has even gone into debt by using a line of credit to bail him out.

"He's my son -- it's hard to say, no and I want to help him," she says.

It's a common refrain among people who lend money to loved ones. While many experts advise against it, people do it all the time to help family members cope with a job loss, start a business, pay for education, buy a house or car or, as in McGowan's case, cover debt.

"It's not a big stretch to see why borrowing money from family and friends can destroy a relationship," says Oliver Harris, a financial consultant with Investors Group in Orangeville, Ontario.

But it doesn't have to be that way. By taking precautions before agreeing to a loan between loved ones, you can avoid a sour loan and family drama.

A paper trail is important
"If people come to me first, I can help them; if they come to me second, I become very rich," says Toronto lawyer Howard S. Dyment, referring to the expensive legal battle that can ensue when a lender tries to get a lax borrower to pay up.

While it may not make financial sense to pay a lawyer $600 to $1,000 to draw up the terms for a loan of less than $10,000, such lenders still need protection. So, make the exchange official with a promissory note outlining terms, such as the amount, interest, a payment schedule and a plan of action should the borrower default.

Make sure both parties sign the document, and keep a paper trail that includes payment details and receipts.

Even with the most common type of loan -- parents helping a married child buy a house -- it pays to be shrewd. When parents simply hand over $100,000, it's a gift to the couple. That's fine if the duo lives a long, happy life together, but what if the marriage falls apart? Do the lenders want their cheating ex-son-in-law to walk away with their $50,000 when assets are divided?

To avoid such a scenario, Dyment advises having a lawyer draft the proper paperwork to draw a $100,000 second mortgage with a reasonable interest rate. The parents may not intend for the couple to pay back the money, but the documents are in place to ensure that if there's a divorce and the house is sold, the $100,000 plus the interest goes back to the parents.

Another key step is redoing the parents' will so if they die, the loan will be forgiven. Otherwise, the couple may have to sell their home to settle the estate.

Taxing concerns
At first, the idea of charging interest on a family loan may cause lenders and borrowers to balk, but there are advantages in doing so.

For lenders, charging a nominal amount of interest, even if it's less than the banks' current rate, is a chance to offset some of the loss they'll incur by lending the money instead of investing it.

It's also a precautionary measure, says John R. Mott, a Toronto-based chartered accountant. "If there's a risk that the loan might go bad, you'd want to have an interest rate on it," he says.

If the borrower defaults, the lender can claim a capital loss with the Canada Revenue Agency, but only if it appears the loan was made to earn income. If no interest is charged, the claim isn't allowed, nor is it granted on loans between close family members, such as parents and children or between siblings. It does, however, apply to loans made to extended family or friends.

Keep in mind, warns Mott, that "technically if you charge interest on a loan, even to a family member, you are taxed on the interest -- even if the interest is not being paid."

Borrowing for business
Loan interest can also be deductible for borrowers starting a business.

Business-related loans are leagued unto themselves, and it's essential to seek specialized tax advice. If, for example, a borrower defaults, the lender can claim an allowable business investment loss.

It's a good idea to make the loan directly to the registered business, rather then the owner. Again, legal documents defining terms, such as whether the lender is making an investment or providing a loan, will prevent hassles in the long run.

Saying no
There are times when lending money to loved ones isn't a good idea. Lenders need to be financially stable and they need to have faith in the borrower's ability and willingness to repay.

Don't be afraid to say no -- explaining you simply can't afford it is less messy than demanding money from a borrower who can't pay. If it's obvious that you have the money but you aren't comfortable lending it, lie -- say your investments are tied up, the market is bad or blame it on a lawyer, financial adviser or accountant.

There are other options if you still want to help, says Harris: "A far better alternative is to offer to co-sign a loan." There's less pressure on the relationship, the borrower establishes credit and there's a better chance the loan will be repaid.

McGowan vows to document any further loans to her son. But, even with proper measures in place, lending money to loved ones is a gamble. As Shakespeare put it: "Neither a borrower nor lender be. For loan oft loses both itself and friend."

Michelle Warren is a writer in Toronto.

-- Posted: July 14, 2005
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