Financial Literacy - Smart Borrowing
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personal loan
Borrowing from friends, family: risky

"You have a promissory note and you have an amortization schedule. If they didn't pay, you sent them letters demanding payment. If you don't hire an attorney and take some serious action when someone fails to pay you -- you would need to justify why you didn't," she says.

Possible explanations for not hiring an attorney include a pending bankruptcy for the borrower and uncollected IRS debts.

"You can make sure that the person lists your loan in their bankruptcy petition. They acknowledge that it is a debt that they aren't paying back," says Bolson.

"Another justification we have used: If this is a person who owes the IRS money and the IRS is not collecting it, in spite of their best efforts -- and they have the best efforts in the world -- if they cannot collect, how can anyone?" she says.

Still, you have the burden of proof.

To differentiate the loan from a gift, lenders must charge a minimum interest rate, which must be at least as high as the applicable federal rate to meet IRS requirements. That rate varies, depending on the loan term, says Fox.

"In the determination of the IRS, a short-term loan is three to five years. Midterm is more than three but not more than nine, and a long-term loan is more than nine," he says.

Applicable federal rate for September 2008
AnnualSemiannualQuarterlyMonthly
Short-term2.38%2.37%2.36%2.36%
Mid-term3.46%3.43%3.42%3.41%
Long-term4.58%4.53%4.50%4.49%
Source: www.IRS.gov

The IRS on loans between friends

"In theory you can take a deduction for a bad debt. It's like a capital loss, so it might be deductible over a long period of time, depending on your overall financial situation," says Adele Brady Bolson, CPA and member of the AICPA's CPA National Financial Literacy Commission.

In general, the capital loss must be claimed for the tax year in which it became worthless. It should be used first to offset capital gains, if any, and after that you can write off up to $3,000 against other income. Whatever you don't use in the current tax year can be carried forward to future years until it's used up, says Bankrate's tax adviser George Saenz.

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The IRS doesn't just go around handing out these deductions, however. The taxpayer has to prove that they weren't gifting the money to the borrower, that it was in fact a loan with a bona fide interest rate.

"If you really, really intended it as a loan, then what you want to do is document the heck out of it so there really is no question if you were to be audited that it was a loan," says Bolson.

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