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There are certain times when we need to stand with family and friends. We feel an obligation to help them overcome financial issues when they do not have the ability to loan themselves. On the other hand, many people will turn to financially secured family members or friends to help them out of a sticky situation, especially if it is unavoidable.
While we cannot change the human side of us, we need to act wisely. The decision of loaning money to friends and family depends on lots of variables and may result in tax implications.
This article attempts to serve as a guide for individuals who want to learn about the advantages and disadvantages of offering a family loan, tax implications, the interrelation between the loan type and the taxation, the right way of loaning money to friends and family, and means that reduce tax implications. Assessing the risks and anticipating the repercussions is necessary because loaning money sounds easier than it really is.
What is a Family Loan?
A family loan is a loan agreement between members of the same family. A basic contract is typically maintained to track the payments and interest due according to an agreed schedule. This contract is usually less formal and forcible than personal loans offered by traditional lenders. Therefore, and to avoid complications and improve legitimacy, lenders may appoint a peer-to-peer administrator to complete the paperwork and collect payments on their behalf.
Is Lending Money to a Friend or Family a Bad Idea?
It all depends on the way the family members consider the loan and handle the payments. In fact, it can create a win-win situation if both sides are understanding and deal with it as team players who want to gain together. Alternatively, it can become a curse destroying the family relationship and causing financial hardships. Therefore, prior making decision, it would be good to answer the following questions:
- What is the exact situation that forces the family member or the friend to request the loan?
If it is a recurring situation, providing a family loan is not a smart idea. Such a requirement usually stems from financial mismanagement. In this case, the borrower will not be able to repay the amount. Therefore, lenders must maintain boundaries as to when to grant a loan to a family member.
- Is the lender able to not interfere in the borrower’s expenditure?
If the answer is yes, the familial ties and the friendship will remain unaffected. Lending money does not imply controlling the behavior of the lender or his/her expenditure. On the other hand, the borrower should not feel awkward for taking the money.
- Is the lender sure about his/her lending capabilities?
Before providing the loan, the lender should calculate his/her own expenses. He/she also needs to learn about the tax implications. The lender must be sure that he/she can withstand payment delays even if there are administrators and written agreements.
- Are the two sides clear about the loan terms?
If you are loaning a family member or a friend, you both need to be on the same page. A written agreement stating the repayment terms and tax implications is important. Remember that unless the lender provides proof of repayment, the Internal Revenue Service (IRS) considers any transaction between family members a gift. Keep in mind that this does not mean the amount is not taxable. The IRS may decide to charge you gift tax which is the responsibility of the donor.
If You Loan Someone Money, Is It Taxable?
On their website, Raiche & Company highlight some important points regarding tax implications of loaning money to a friend and family:
- Any amount that exceeds $599 must be declared on either person’s tax return.
- Each parent can gift their child $,15,000 as a tax-free gift once a year. However, the total amount given as a gift for each child should not exceed $30,000.
- Any amount that exceeds $10,000 is taxable. The lender becomes subject to “below market interest rules”. In other words, the lender must pay interest even though below the prevailing banks’ interests. In this respect, the applicable federal rate can be a tax over an interest the lender has not received.
- Even if the lender tempts to get an interest lower than the market rate, he/she will be in charge of paying the market rate.
- There are tax implications of loaning money to a friend for business even if the amount does not exceed the $10,000. That is because the borrower uses the money for the purchase of equipment that produces income such as real estate rental or business equipment.
- In any case, whether you charge interest or don’t, there are tax implications for lending money to a family. Even if you decide to gift an amount that does not exceed $10,000, the gift tax applies.
How to Loan Money to Friends and Family the Right Way?
- Step#1: Consult with your certified public accountant (CPA)
The CPA is the best person to advise regarding the amount you can offer, its tax implications, and the structure of the transaction.
- Step#2: Make sure you charge an adequate interest rate
To avoid unfavorable tax implications, make sure you charge an interest rate that is at least equal to the federal below market rate and approved by the IRS at the time of signing the agreement.
- Step#3: Make sure that the borrower is aware of his/her rights and responsibilities.
Borrowers of family loans should be informed that they will not be able to deduct interest to adjust their gross income. The only way this will be possible is to secure the loan with a home property.
- Step#4: Fulfill the legal requirements and paperwork
Have a written and signed agreement describing the loan amount, the interest rates, the repayment terms indicating dates and late payment consequences, the collateral for securing the loan (i.e., personal property). At this point, a peer-to-peer administrator may be appointed to do the necessary paperwork and follow the collection of the dept.
- Step#5: Make sure you keep track of things
The loan agreement does not end but starts the moment it is signed. Therefore, it is essential to maintain track of each transaction made. Recordkeeping helps knowing the loan balance and calculating applicable taxes easily.
Without any doubt, supporting struggling family and friends at turbulent times is a generous act. However, rest is where the good way is. Therefore, stand by the way, assess the risks of offering the family loan. Tax implications must be clarified to the borrowing family or friend prior to signing the agreement. Eventually, loaning the right way and going there keeps you safe from potential disputes.