Important IRS rules on Family Loans that You Should Know About

It is best to learn the tax rules, benefits and risks before you consider lending money between family members. Doing so have two consequences either beneficial or a disaster.

But, should you do it or not? It is kind of tricky to say yes or no. 

As a matter of fact, your family may be the best place to get a loan from. It can be a great deal for the borrower of the loan from family members. You may have heard about the common warning which is: Never lend money to a family member.

Personal and financial downsides, and also tax consequences are possible in this kind of loan. And, before making a family loan, below are a few things you should know.

How can you describe what family loan is?

From the word “family loan”, it literally means a loan between family members and is sometimes called an intra-family loan. Compared to a peer-to-peer marketplace or traditional loans from traditional lenders (which connects borrowers directly to potential investors), family loans are often less formal. 

Contracts or simple contracts may not be available in a family loan. Through this contract, interest due and repayment schedule can be tracked by the borrower or lender. 

For both the borrower and the lender, a loan is a contract and has potential tax consequences: On any interest that the lender charged, there is a corresponding tax. 

Things will become more complicated if the lender doesn’t charge interest. Taxes on “imputed interest charges” are required to be paid by the lender, according to the IRS. It is the estimated amount of interest the lender should charge from what the IRS thinks.  

Advantages of family loans

• Interest rates are low: Compared to a bank loan, the family loan has the lowest interest rate. 
• Bad credit is not a big deal: Even if your borrower’s credit history is a little messy, that will not stop your family member to let you borrow money. 
• Mutual benefits: You may get a loan that has better terms than from average loans and the interest that you will pay will be to a family member and not to an unknown lender. 

Disadvantages of family loans

• Tax consequences: Both the borrower and the lender have to follow tax rules when dealing with a family loan. Lenders have to pay interest on income not earned if they offer a below-market rate, as well as income earned from the loan. But lenders can claim the cancelled debt as income or borrowers may have to repay the debt as agreed, then an exception applies. 
• Paperwork: You may want to draft a written contract or a promissory note that includes a promise to repay the loan, tracking interest owed, payments and more when you give a family loan. 
• Family dynamics: Family tension maybe there especially if a family member who lent money broke a loan agreement. 
• Credit history: A loan from a family member won’t improve your credit history unless they are reporting your loan payments to the three main credit bureaus. 

When should a family loan be considered?

It can be risky getting a loan from a family member. Think about putting the following conditions in place before any money changes hands. 

• Loan terms: Before making a loan, the repayment schedule and interest rate should be agreed upon between the borrower and lender. It should be in a signed contract or promissory note.
• Legal remedies: The lender has an option to decide whether to absorb the financial loss or to sue a family member if the borrower defaults on the loan. It may not make sense to lend your money if you cannot afford to lose it. 
• Loan restriction on use: You better think twice if your purpose of family loan is to make a mortgage down payment because a family loan is not considered as a valid source of funding. 

How to make a family loan legitimate for tax purposes?

Consider the following steps to make sure your loan is a real deal in the eyes of the law. 

Repayment schedule agreement

If a loan between family members doesn’t have a loan agreement, it can be complicated. So, it is best to set a repayment schedule either every month or in a few years. 

Interest charge

A minimum interest rate that the IRS set is called the applicable federal rate. Whether a loan is a short term (three years or less), midterm (over three years but not more than nine years), or long term (over nine years), the minimum interest rate varies. The annual applicable federal rate for a short term loan as of February 2019 was 2.57%. The lender have to pay taxes on the unearned interest if he doesn’t charge at least the applicable federal rate. 

Put it in writing to keep records

A piece of concrete evidence for you showing that there is an expectation to enforce the debt repayment terms. It is best to keep track of the record payments, the balance of the loan, and interest to help with taxes and for the family members to be on the same page. 

If you have trouble deciding what’s best, it may be worthwhile to consult a tax professional.