Use Caution when Lending Money to Family and Friends
August 14, 2014
It seems like every family has that one uncle who can never seem to get ahead or the brother-in-law that has a different get-rich-quick scheme every time you see him. But what do you do when they ask you for a loan? It is an unpleasant situation that most of us either have experienced or will face at some point.
Some of us have more money and material wealth and some of us have less — it’s a fact so banal that we don’t lose much sleep over it. But that generally accepted lopsidedness in the the social state of affairs can become a source of acute jealousy, guilt and good intentions gone wrong when it comes to family and close friends. A plea from either can be powerful. Who doesn’t want to lend a helping hand to those we’re closest to? But before you decide to provide financial rescue, you might want to consider a few things.
First, when making a loan to a family or friend, you should be prepared for the possibility that you will never see that money again. Don’t lend money that you can’t afford to lose. If not being repaid will impact your financial stability, you simply shouldn’t do it.
Second, just because the loan is between you and a friend or family member doesn’t make the transaction a casual deal. It is an investment and should be treated with a certain level of formality. Prepare a loan document or promissory note that sets forth the terms of the loan — how the loan will be repaid, over what period of time and the interest rate. This will keep you out of trouble with the IRS as well, because it makes it clear that the funds were a loan and not a gift.
The IRS considers waived interest a gift, so avoid the temptation to make it easy on the struggling borrower by not charging any interest. Each month the IRS publishes a minimum rate that should be charged, called the Applicable Federal Rate. Ask your accountant for guidance on the tax implications. Don’t forget that the interest you receive has to be reported as taxable income on your personal income tax return.
If you end up forgiving the loan or any part of the interest, that is the same as making a gift. Gifts that exceed $14,000 require that you file a gift-tax return and will cut into your lifetime gift- and estate-tax exemptions.
Once the loan is made, be sure to document the payments. Over the course of several years, borrowers may think they have paid more than they really have. Impeccable record keeping can settle disagreements or misunderstandings and help avoid damaging the relationship.
It is easy to understand how relationships between family members or friends can become strained by a loan. The last thing anyone wants is to dread a birthday party or Thanksgiving dinner because of a neglected loan. Or worse, see it fester into grudges and irreparable falling out. By following these few suggestions, you might be able to avoid hurt feelings and hot water with the IRS. In “Hamlet,” Polonius advises, “Neither a borrower nor a lender be, for loan oft loses both itself and friend.” Sage advice that is still true today.
Phoebe Venable, chartered financial analyst, is president & COO of CapWealth Advisors LLC. Her column on women, families and building wealth appears each Saturday in The Tennessean.
