Family Loans - Doing It The Right Way

By Author: Jamie Hanson
Total Articles: 3495
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There are many reasons why people turn to family members for help when they are cash-strapped. Unlike banks and lending agencies, family members don't usually impose stringent rules upon each other. For starters, you don't really have to submit any documentation for you to qualify for the loan. Also, you are either charged a minimal interest rate or none at all.

But loaning money to family members actually needs serious thought and planning. There are tax implications that, if ignored, may very well mean costly consequences for you.

Charge Interest
It is understandable why a lot of people are reluctant to require relatives to pay interest on loans. You don't want to seem unsympathetic to their situation. But take note that even if you decide to overlook the interest, the IRS will not. There is such a thing called "imputed interest." This basically means that the IRS will assume that since this is a loan, it naturally must have interest. And that interest is taxable income. If you don't charge interest then you will end up paying taxes on income that you really didn't earn.

If you do not ...
... wish to charge your relative a rate that is too steep, you may opt for the applicable federal rate or AFR. The AFR is the minimum interest rate that the IRS imposes on family loans. The AFR changes accordingly with the Treasury bill rate.

Get It in Writing
Another way to make sure you do not get into trouble with the IRS is to record the transaction in detail. First, you must establish that the loan is indeed a loan. Include other details such as interest rates, agreed-upon payment schedules and so on. In addition to this, you need to certify that the borrower is solvent, meaning, he is capable of fulfilling his financial obligations. Have him write a letter that states this.

If you fail to do these, the IRS will treat the money that you loaned to your relative as a gift. Therefore, the rules on gift taxes will apply and the lender is usually the one required to pay these taxes.

Do Away with Imputed Interest
Now if you want to steer clear of imputed interests and gift taxes, there is a way around these rules. You can get away with not charging interest and do not have to pay gift taxes as long as the loan does not exceed $12,000. Furthermore, the loan must not be used for income-generating purposes such as bonds or stocks.

The second option is the $100,000 exception. Under this rule, the loan that you extend to your relative must not exceed $100,000. If your relative earns an annual net investment income of $1,000 or less, you will not be charged by the IRS. If the net investment income exceeds this limit, the imputed interest is applicable only to the actual investment income earned.

Helping out a family member during financial hardship is not discouraged. But it is vital to be aware of the possible risks that you may face so you can make informed decisions about what to do with your money.

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