Once your loans to one relative or friend pass $10,000, charging less than the applicable federal rate, a benchmark the IRS publishes monthly, can mean paying income tax on interest you never collected. On loans totaling $100,000 or less, the IRS’s rules for these below-market loans cap the interest you’re taxed on at the borrower’s yearly net investment income, such as savings interest, and at zero when that’s $1,000 or less.
Interest is only one of the terms a family loan needs in writing. Without written terms, each of you can remember a different deal about when payments are due, how much they are, and what happens after one is missed. Settling those questions up front, the way a bank would, protects both the money and the relationship.
1. Don’t say yes on the spot
Ask for a day or two to check your own budget, however clear the answer feels. A yes given in the moment comes before you know what you can spare, and it’s harder to add terms to a promise you’ve already made.
2. Lend only what you could afford to lose
Keep the loan to an amount you could afford to give away if it never came back, never money your emergency fund or next month’s bills depend on.
3. Hear the request out in a sit-down
Set a time to talk it over in private, away from family gatherings. Ask what the money is for, the exact amount, how they’ll repay it from their income, and whether a bank or credit union has already turned them down. Vague answers about repayment are a reason to slow down or say no.
4. Know when to say no
Turn the loan down when any of these is true:
- They won’t agree to a payment schedule, which would leave the loan open-ended.
- You expect them to repay you last, after every other bill.
- A yes now would make you the one they ask whenever money runs short.
- The money would keep a gambling, drug, or overspending problem going.
- Lending to one relative would leave others in the family resentful.
When the answer is no, turn the request down kindly and briefly, without a long explanation of your finances.
5. Charge interest
On a loan that takes the total past $10,000, charge at least the applicable federal rate. The IRS’s monthly table has a short-term rate for loans of up to three years, a mid-term rate for up to nine, and a long-term rate beyond that. A loan with a fixed end date keeps the rate in effect the month you make it.
A loan that keeps the total at $10,000 or less can carry a lower rate or none. The exception is money the borrower uses to buy investments, such as stocks or a rental property, which falls under the below-market loan rules at any amount. Even a low rate written into the note gives the borrower a reason to pay you before they pay for extras.
6. Agree on a late fee
Skip the upfront fees a bank charges, which only add to what a relative short on cash owes you. But write a late fee into the note, a flat amount due once a payment is more than a week or two late, so a missed payment carries a cost you both agreed to in advance.
7. Set an end date and a payment schedule
Give the loan an end date and a fixed payment, due a day or two after the borrower’s payday, before other bills use up the paycheck. Ask them to set up an automatic transfer to your account, so neither of you has to bring it up each month.
8. Take collateral on a large loan
For a large loan, ask for something of value as security, and spell out in the note what you can claim after a set number of missed payments. Pick something the borrower can do without, such as jewelry or a spare vehicle, never the car they drive to work, since taking it would cost them the income that repays you.
9. Sign a promissory note
Put the terms in a promissory note, a written promise to repay that you both sign and each keep a copy of. It lists the amount, the interest rate, each payment’s size and due date, the end date, the late fee, and any collateral. It also says what happens after a missed payment, such as the whole balance coming due after two in a row. The signed note is your evidence for the IRS that the money was a loan, not a gift.
10. Tell the rest of the family
If you share finances with a spouse or partner, agree on the loan together before you offer it. Then tell anyone else it affects, such as a sibling who might ask for the same help, that it’s a loan with terms. A loan kept quiet looks like favoritism once it comes out.
11. Don’t micromanage the borrower
Once the money is out, ask about missed payments and nothing else. Questions about how they spend the rest of their money breed resentment, and the note already says what happens when they fall behind.
12. Don’t treat cosigning as the safer option
Cosigning a bank loan for them instead isn’t safer than lending, since the lender can collect the whole debt from you, and their late payments can show up on your credit report. Cosign a loan only if you could repay all of it yourself.
13. Know the tax rules
Report the interest you collect as income, since the IRS taxes interest on loans you make to others just as it taxes bank interest. Forgiving what’s left can count as a gift, and a gift above the annual exclusion, the amount you can give one person each year without reporting it, requires a gift tax return.
A family loan that’s never repaid can be deducted in the year it becomes totally uncollectible, as a short-term capital loss that offsets investment gains and a limited amount of other income. Only a genuine loan qualifies. Under the IRS’s bad debt rules, money you lend a relative or friend when you both know it may never be repaid counts as a gift.
So sign the note before any money moves, and have the borrower schedule the first automatic transfer for the day after their next payday.
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