What You Need to Know About Family Loans and IRS Rules

Lending money to a family member (or borrowing from a family member) may seem like a good idea: the borrower gets easy approval, and any interest paid is left to the family rather than to the bank.

In many cases, family loans are successful, but success requires a lot of open discussions and planning. You have to deal with administrative problems and the emotional aspect (perhaps more complicated) of things.

To work well, focus on three main areas:

• Protect your relationships
• Protect the financial lender (including employees or heirs)
• Avoid problems with the IRS

It is also necessary to overcome legal obstacles, such as local laws on robbery and abusive practices in debt collection.

What is a family loan?

A family loan, sometimes called an intra-community loan, is a loan between family members. Family loans are generally less formal than personal loans from traditional or peer-to-peer (P2P) credit institutions, which directly connect potential investors to borrowers.

On the other hand, family loans cannot have simple contracts or contracts in which the debtor or creditor monitors the outstanding interest and payment terms.

Informal family loans can make sense of family dynamics. Still, a loan remains a contract, and loans can have tax consequences for both the borrower and the lender: a creditor who charges interest will have to pay tax on the loan from the debtor.

If the lender does not charge interest, things get complicated. The IRS asks the creditor to pay taxes on "imputed interest rates." The imputed interest rate is the estimated amount of interest that the IRS believes the creditor should have received.

If keeping tracks of interest, payments, and taxes is a puzzle, you can pay an equivalent loan manager to manage documentation and collect payments for you.

Advantages of family loans

• Rough credit is not a problem: there is nothing to prevent loans from family members, even if the credit history of the borrower is a little banged up.
• Low-interest rates: In some cases, family members lend to other members at a lower interest rate than a bank.
• Mutual benefits: A borrower can obtain a loan with above-average loan terms, and the interest is paid to a household member rather than an unknown lender.

Disadvantages of family loans

• Documentation: When you take a family loan, you can create a written agreement that includes a commitment to pay back the loan. This type of agreement is termed a promissory note. You can also track interest due, payments, etc.
• Tax consequences: In the case of a family loan, the borrower and the lender must comply with the tax rules. Lenders may be required to pay interest on loan proceeds and unearned income if they offer below-market rates. If an exception does not apply, the debtors may be required to claim the canceled debt as income or to pay the debt as agreed.
• Family Dynamics: Will the Thanksgiving dinner be put on hold if your brother still owes you $50,000 to pay in the summer? Broken loan contracts can cause stress in the family.
• Credit history: Unless the loan payments are being reported to the first three credit bureaus, your credit history will probably not improve with a family loan.

When should I consider a family loan?

Loans between family members can be risky. Before changing hands, consider introducing these conditions.

• Loan terms: The borrower and the lender should ideally agree on a repayment plan and an interest rate before making a loan. The terms of the loan must be included in a signed contract.
• Legal remedies: If the borrower does not respect the credit, the lender must decide whether to sue a family member or absorb the financial loss. If you cannot lose money, it may not make sense to borrow it.
• Limits of Use: For example, cash advances from unsecured loans, including family loans, are sometimes not considered to be valuable sources of mortgage financing.

Tips for Legitimizing a Family Loan for Tax Purposes

Although a handshake between family members is a loan agreement, the IRS assumes that there are cash transfers between family members unless there is no evidence that the creditor expects to respect the terms of repayment.

Follow these steps to make sure the loan is the real deal in the eyes of the law.

Accept a payment plan

Family loan rules can be complicated if the loan agreement does not include repayment terms. A good practice for loans between family members is to establish a repayment schedule. The borrower can make a payment every month or repay the loan in a few years.

Interest rate

The Internal Revenue Service (IRS) introduced a minimum percentage rate called the applicable federal rate. The minimum interest rate varies depending on whether the loan is short term (three years or less), medium-term (more than three years, but not more than nine years) or long term (more than nine years).

In February 2019, the federal annual rate applicable to a short-term loan was 2.57%. A creditor who does not collect at least the applicable federal tax should pay taxes on the unknown interest.

Put it in writing

Although a handshake is technically a loan agreement, writing the payment terms offers something concrete that shows the creditor must meet the debt repayment terms.

Keep your records

The documentation does not stop after the loan is issued. The borrower and the lender must record payments and monitor the balance of the loan. Good record keeping will help reduce taxes and keep family members on the same page.

Tax rules for gifts and loans can be complicated. If you are not sure about the tax consequences of a family loan, it may be worthwhile to consult a tax professional.

Bottom Line

Ideally, a family loan creates a mutually beneficial situation for both the lender and the borrower. But if the family loan goes awry, it can hurt your relationship, if not your credit score.

Before lending or borrowing money to family members, consider all the possible consequences. If the loan still makes sense to both parties, make sure everyone is on the same page, write the loan in writing and oversee the payments.