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Family Loans: IRS Rules You Need to Know

Family Loans: IRS Rules You Need to Know

Borrowing money from family members can be a risky business. And while all debt is risky, family loans come with all kinds of dangers.

In spite of the fact that family lenders don't have to worry about lowering (or worsening) their credit score, private lending can hurt strong relationships. Depending on the loan amount, there may be tax implications to consider.

That being said, there are ways to issue and receive family loans with care. Here are our top tips for stacking the odds in your favor.

What is a family loan?

Family loans are loans made and received within a family group, rather than in a typical credit situation, such as a bank, credit union, or even a lender.

A person who may not be eligible for a traditional loan may be inclined to take out a loan from a family member.

Sometimes a family loan can work in the best interests of both parties. For example, the borrower may receive a more favorable interest rate than they would receive from a bank, and the lender may receive a higher interest rate than they would find in a savings account.

The reasons someone might take out a loan from a family member are similar to what they might consider a personal loan - you might need money for emergency medical bills, unexpected repairs at home or adoption, or fertility treatments.

How do family loans work?

In their most basic form, family loans work the same way as traditional loans – one person applies for a loan, and another approves the application. Although this is an oversimplification, the concept is the same. There are generally fewer documents in a family loan, with no credit application or verification required. However, a formal contract specifying the rights and responsibilities of each party is recommended.

Conditions that the lender must include in a family loan

  • Amount of the loan.

  • Interest rate, if interest is charged.

  • Payment amount (usually monthly).

  • Fines for non-payment.

Conditions for the borrower to be included in a family loan

  • Amortization schedule, with clearly defined principal and interest.

  • Possibility of prepayment of the loan without penalties.

  • Periods of suspension of payments in the event of difficulty.

Risks and Benefits of Family Loans

No matter which part of the dynamic you find yourself in, family loans come with risks and rewards. But while both the borrower and the lender are likely to pressure the family relationship involved, the lender is likely to bear the greatest financial risk; After all, it can be very difficult to recoup your losses when you don't have official financial authority.

Risks associated with family loans

One of the biggest borrowing risks between family members is a potential conflict in the relationship. People tend to have strong emotions about money. However, some risks are solely the responsibility of the borrower or lender.

Risks for the borrower:

  • Although it is advantageous to avoid credit checks and possible negative consequences on credit, family loans do not help borrowers establish their credit history because they are not reported to the credit bureaus.

  • There is a risk to the relationship if the loan repayment plan fails.

Risks for the lender:

  • Because family creditors lack authority or financial support, it can be difficult to recover losses or impose significant consequences on debtors who have no obligation.

  • If the loan is interest-free and worth more than excluding IRS gift tax, you may have to file a gift tax return (and possibly pay gift tax).

  • It is easy for family creditors to completely lose their money if the borrower consistently defers to an IOU.

  • There is a risk to the relationship if the loan repayment plan fails, which puts the lender in a particularly difficult position if he needs a repayment due to the financial situation.

Tax implications of family loans 

It may come as a surprise to learn that lending money to a family member can be a big enough issue to appear on the IRS radar.

Fortunately, most family loans fall outside the purview of the IRS. Only when they are greater than the amounts set by the IRS and without interest should creditors report them on the tax return.

If a family lender provides an interest-free loan to a family borrower, the IRS still considers the transaction a loan and assumes that the interest charged should count as a gift to the recipient. 

It doesn't matter if the loan is, say, $200. But if the unpaid interest or outstanding loan balance exceeds the annual donation exclusion, which is $15,000 for 2021, the lender may be required to file a tax return and possibly the payment of gift tax.

The IRS may also count the interest that must be on the lender's gross income, even if no interest is received or charged. Again, this is not a big deal with rates below 1% on loans of a few hundred dollars, but it can hurt the lender's finances with a large enough loan.

How to legitimize a family loan for tax purposes

The primary thing that makes a family loan legitimate for the IRS is a family loan agreement that specifies payment terms. If no agreement is reached, the agency may consider it a gift rather than a loan.

The federal government sets the minimum interest rates (applicable federal rates) that lenders can charge for a private loan, which is a family loan. If an interest rate is charged below the minimum level, the IRS may impose any unpaid interest deemed due.

The record of payments made will also show the IRS that the creditor is pursuing the debt, and payment is expected.



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