Lending money to family tax implications is often overlooked due to the casual agreement that is present in family loans. It is important, however, to consider the tax implications that are involved with lending money to family and friends.

Loan Agreements with Family and Friends

Lending money to family and friends is extremely common, with an estimated $89 billion dollars lent in just the United States. There are many reasons that people lend money to family members, including to start a business, to pay off debt, and to buy a house. Families also often borrow money from one another when they hit hard financial times due to things like unemployment or expensive medical issues.

Charge IRS-Approved Interest

It does not occur to many to charge their family members interest on personal loans. However, failing to do so can result in tax complications. IRS-approved application federal rates (AFR) are low and affordable, and they protect both the borrower and the borrowee.

Minimum rates are currently set at just 0.38% on loans of less than three years and 1.85% on loans between three and nine years long. AFRs fluctuate monthly, so it is a good idea to check the current rates when agreeing to lend family or friends money. Current AFR rates can be found on the IRS website.

Tax-Smart Family Loan Strategy in Action

The specific loan strategy used will depend on the purpose of the loan. Regardless of the loan type, though, the lender can include the loan amount on their federal tax return. There may also be advantages to the borrower. The borrower, for example, may be able to claim the interest on their mortgage as a tax deduction. Each of these situations requires that there be a legal document in place stipulating the terms of the loan.

Why You Should Avoid Interest-Free Loans

Interest-free loans are never a good idea, even those made to trusted family members or friends. An interest-free loan is subject to below-market interest rules. Calculating imaginary interest payments is a difficult process. Imaginary gifts can also cut into federal tax exemptions.

Paying attention to the details of the loan will ensure that the lending process is smooth for both parties. Lending money to family should include a well-drafted document that includes the following parts:

  • The loan terms should be in writing.
  • The contract should clearly state that the money is a loan and not a gift.
  • Include the loan amount, the interest rate, and the specific repayment terms.
  • Include transfer stipulations in the promissory note.
  • Include nonpayment recourse actions, including adding costs to the loan, changing the terms of the loan, taking ownership of the collateral, or taking legal action.
  • The document should clearly indicate what the loan is being used for.
  • Include any additional necessary legal documents, including a deed of trust, mortgage paperwork, or business ownership documents.
  • Dictate whether or not the loan is secured or unsecured.
  • Collect loan interest payments on a regular schedule.

Imputed Income

Imputed income is income that is earned but is not recognized. The IRS has the ability to place interest on a loan at the AFR when no other interest or the minimum amount is not currently being charged. When interest rates are not collected, the agency can set their own rate based on current tax rates.

Bad Debt Reduction

When money is lent for business purpose and the loan is not repaid, that loan amount may be deductible. However, when that failing loan deduction comes from a family member, the IRS might require additional documentation to prove that the loan actually occurred. The amount cannot be deducted if the loan is considered a gift. There must be proof that shows it as a loan and not a family gift.

How to Borrow From Family or Friends

There are advantages to borrowing from family and friends over a traditional financial lender.

  • The lender is more likely to be lax in terms of repayment arrangements.
  • There are no limitations as to the amount you can borrow.
  • Interest rates tend to be lower than with traditional lenders.

Unfortunately, there are also risks to borrowing from family and friends. You run the risk of damaging the family relationship. You can prevent this by implementing the same interest requirements and professionalism that would be involved in a traditional lending agreement. Utilize the same promissory note setup that would be used with an actual lending institution.

If you need help with lending money to family tax implications, you can post your legal job on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb