How To Handle Family Loans
It is common for people to first turn to family members and relatives with their money problems. They do not usually charge high interest and impose difficult regulations like banks and lending establishments. No documents are also required for submission, and if they charge interest, it is often very low.
But be careful — you’ll still need to do your homework when family members start asking you for money. Certain tax implications might cost you in the long run.
Charge interest, even if it hurts.
It is common for us not to charge any interest when we lend our relatives money, just because they are “family.” However, the IRS does not think the way we do, even if we do not charge interest. They may charge you with “imputed interest.” Imputed interest is when the IRS thinks that since you loaned money to somebody, it automatically means there is interest – and interest means tax. Not charging your relatives interest will still require you to pay tax for the loaned money, even if you did not get any profit from the loan.
A good guide for family loan interest rates is the applicable federal rate, or AFR. This is the minimum interest rate that the IRS uses for family loans, and depends on the Treasury bill rate.
Get It in Writing
Putting the information about the family loan in black and white is one way of avoiding issues with the IRS. You have to first have an agreement with the relative(s) that it is indeed a loan. Put into writings the interest rates, fee schedules, and other terms of agreement. Make certain as well that the relative you are lending money to is solvent – meaning, is able to pay off the debt on time. Have them make a promissory note.
If you don’t get things in writing, the IRS might consider the loan a gift — and impose gift taxes. Naturally, the lender — you — will be obliged to pay up.
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.
Another solution against these taxes is when the loan is below $100,000. When the borrowers only have an annual salary of less than $1,000, they will not be required to pay the taxes. But if the salary goes beyond $1,000 yearly, the imputed interest will be based on that amount.
It’s always a good idea to help out family members who need the money, but always know about the risks you may face. That way you’ll be making wise financial decisions with the money you’ll be lending.