6 Tips on How to Safely Give Loans to Friends and Family
Nothing can come between close friends and loved ones as quickly or cause more hard feeling than money issues. Any one of us have or could find ourselves in a position where we fall short on money and may need a quick loan. When looking for help, oftentimes friends or family are the first people we turn to in a pinch. Is it a good idea to borrow money from them? More so, is it a good idea to lend the money if you are the person being approached to help someone out of a sticky situation? Since money tends to be an emotional issue for all parties involved, it is best if you are borrowing or loaning money in this situation to have a few ground rules to avoid a misunderstanding that can ruin the relationship. In addition to protecting your relationship with each other, you want to protect your relationship with the IRS by learning how the loan is viewed by the IRS.
Documentation
To avoid paying income taxes on money you never received and gift taxes on money you haven’t given away, be sure to document that the money is given as a loan. You will want to include interest rates if applicable, payment terms and collateral (if any) is used to secure the loan. This documentation can easily be done without a lawyer using a document-creation software program.
Establish Interest Rate
While you may not be interested in charging interest, it is recommended you do so. Otherwise it is likely the IRS will do it for you. It might serve you well to learn how this loan may effect your for tax purposes and how the IRS relegates loans or gifts of money between family. This is one situation where interest free does not equal hassle free.
Establish Solvency
To prove that this is a loan and not a gift, document in some way that the borrower was solvent at the time of the loan, which gives you a reasonable expectation for repayment.
Keep Records
Before and during the term of the loan, stay organized and keep records indicating you are loaning the money and not gifting it. Also track all payments made. If at some point the worse happens and you find yourself unable to collect payments, make a written request asking for repayment. If this fails to produce results, you will then be required to claim a “nonbusiness bad-debt deduction”. This is the worst case scenario because if it gets to this point, not only may you be out money, but the relationship might be ruined as well.
Take the time to think through all the possible repercussions, financially and emotionally before lending a friend or family member money. You might in fact be doing them a great favor, with good results on both sides. As long as both parties are aware of how the loan will be viewed by the IRS, and take the steps to protect themselves, loans between family members and friends can be completed safely.