CERTIFIED PUBLIC ACCOUNTANTS AND ADVISORS |
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SHOULD YOU
LOAN MONEY TO FAMILY MEMBERS? Lending money to family often is not a good idea, say
many financial experts, but with interest rates at some of their lowest levels
in years, families may find it difficult to resist. Family loans also can be a
way to pass on part of the family estate. So if you decide to loan money to a
family member, proceed with caution, say CERTIFIED FINANCIAL PLANNER™
professionals. Let’s say you loan money to your son to buy a home or
start a business. The IRS may require you to charge a minimal interest rate,
known as the applicable federal rate, for the loan. If you charge below the
rate, or make an interest-free loan, the IRS may impute the difference as
interest earned and consider it taxable income. In some cases, the IRS could
characterize the entire loan as a gift, subject to gift tax. The imputed interest rules don’t apply under certain
circumstances: for loans of less than $10,000 as long as the loan is not used
to buy income-producing assets, and for loans up to $100,000 as long as the
borrower’s net investment income doesn’t exceed $1,000 for the year. In loans where the imputed interest rules apply, interest
rates are set monthly by the IRS and depend on the length of the loan. For
example, if you loan money to your son with the plan that he will repay the
loan within three years, the minimum annual interest rate you would have had
to charge according to the May 2002 rates was 3.21 percent. For loan periods
of three to nine years, the annual interest rate was 4.99 percent, and for
nine years or longer, the rate was 5.85. You may choose to forgive some of the interest payments
should you not need the cash or your child or relative is facing a tough
financial situation. And you probably won’t be liable for any gift tax if
you can use the $11,000 annual gift-tax exemption. The catch is to be sure
that you don’t agree in advance to forgive the loan or end up forgiving all
of the interest payments. Otherwise, the IRS will likely treat the entire loan
as a gift subject to gift tax. Such low-interest loans can be a good deal for the family member. A 5.85 percent annual rate on a loan for a child buying a home would certainly be better than the rate offered by commercial lenders. And the rate could benefit you as well. In May, ten-year Treasuries were returning around 5.2 percent. Still, even with these potential advantages to your child
and yourself, treat intrafamily loans very carefully. Loans gone sour can create
much bad blood in families and could end up the courts. First, is the family member receiving the loan a good
credit risk, or does he or she have a history of not fulfilling promises?
Lending money for a mortgage might earn you better money that a Treasury
security, but the loan isn’t guaranteed. Second, is the purpose of a loan a sound one? Lending money
for a mortgage or perhaps college might be a good idea, while lending money to
bail a person out of debt or to start a business is probably riskier. In the
case of a business, for example, have the relative seek other sources of lending
such as a bank or a venture capital firm. If institutions are unwilling to lend
or invest, perhaps there’s a sound business reason they won’t. If they are
willing to lend the money, often it’s best to let them. Draw up formal documents, with generic preprinted documents
or, preferably, with the help of an attorney. Put in writing the terms, interest
rate, payment schedule and so on, and keep track of all payments. This not only
helps all parties treat it as a real loan, it can prove invaluable should the
IRS question the loan. Say your child fails to repay you. You may be able to
convince the IRS that this is truly a bad loan for which you can claim a
bad-debt loss—versus a slick way to transfer some of your estate to your child
free of tax—if you can show past payments, efforts to collect, sale of
collateral or, heaven forbid, lawsuits filed for payment. Formal documents can help the borrower as well. A
promissory note secured by a mortgage, for example, would allow the borrower to
deduct the interest payments (though this may involve additional legal issues
and additional expenses such as title insurance). And don’t just assume that if they don’t pay it back, you’ll simply chalk it off and consider it a gift or an advance against their inheritance. There can be tax consequences and other heirs may resent the loan forgivenes.
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