There are a number of good reasons to loan money to family members and friends. Sometimes it is to help finance the purchase of a first car or home or to help cover periods of unemployment or retirement situations. Regardless of the reason for making the loan, there are some basic steps that must be followed when making a loan to a family member.
First and foremost, the family member who is loaning money should ensure that the terms of the loan are reduced to writing. Specifically, the lender should have the borrower sign a promissory note. The promissory note should identify the parties, spell out how much money was loaned, specify an annual percentage rate of interest and the finance charge, setout the procedures to be followed if the borrower defaults on a payment, and list any property that is held as security for the loan..
The interest rate that is specified in the promissory note should be “reasonable.” If the interest rate is not “reasonable” then the IRS may declare that the loan is invalid and the lender may incur a gift tax liability (assuming that the loan amount was for more than $12,000, which is the current annual gift tax exclusion amount). With below market interest loans, the IRS may also deem the lender to have gifted the amount of interest to the borrower and deem the borrower as having paid the interest. This can result in the lender having to report and pay income taxes on interest payments that they are deemed to have received.
If any property is held as security for the loan, the lender should take steps to secure the property. How to secure property varies from state to state and depends on the nature of the property. In some cases it is necessary to take possession of property and in others it is sufficient to file financing statements with the state or local government offices or simply to re-title ownership of the property.
While it may be difficult to ask a family member or friend to provide security for a loan, providing security can end up benefiting both parties. For example, if the borrower were to suffer a financial downturn and file bankruptcy before the loan is repaid, the relative or friend lender may be able to get paid before the borrowers other unsecured creditors (such as the borrower’s credit card company).
Including a provision in the promissory note for how the lender is to proceed if the borrower defaults on a payment increases the chances that the lender will be able to deduct the loan as a “bad debt” should the borrower fail to pay. The tax code provides that personal “bad debts” are deductible in the year in which the loan becomes worthless. The tax regulations specify that it is not necessary for a lender to take steps to enforce a debt for it to be “worthless;” however, it is often difficult to prove that a loan is “worthless.”
Lenders may want to include a provision in the promissory note that specifies that the lender only has to send one letter to the borrower after the borrower misses one or more payments and that the borrower will have defaulted on the loan if he or she does not does not bring the debt current within a few days. Lenders can then retain a copy of the letter (and proof that they sent the letter) to establish that the debt was “worthless” and therefore deductible in a particular tax year.
These simple steps can go a long way in resolving any misunderstandings and hard feelings should the loan not work out as the parties planned.