A Delicate Matter – Lending Money to Family and Friends
Making a loan to a friend or family member may result in not only the loss of money, but can also damage relationships with your loved ones. There are times, however, when a loved one needs financial assistance and you may want to help them out. You should proceed with caution to limit the risk, both to your bank account and to your relationship with the borrower:
Never lend more than you can afford to lose. Even the most responsible individuals can be faced with unexpected difficulties, such as an illness or divorce that may hamper their ability to repay the loan.
Find out how the money will be used. Like any lender, you should inquire about what the borrower plans to do with the money. Be wary if the borrower is requesting money to pay for groceries, rent or other recurring expenses. What’s going to change next month? Try to discuss the steps they will take to obtain the funds to repay you. For example, have they taken on a second job or curtailed some of their expenses?
Put the terms of the loan in writing. This should include the amount of the loan, how the funds will be used, the rate of interest and schedule of repayment, as well as the actions you’ll take if the borrower defaults on the loan. Laying out the terms of the loan reduces the risk of a misunderstanding. It also substantiates that the transaction was a loan and not a gift — an important difference for tax purposes, as noted below.
Require that repayments be made via a method that can be documented. Repayments should be made by check or through an online service like PayPal – not in cash. This lessens the chances of a disagreement over how much of the loan has been repaid.
Potential tax implications. The IRS may try to re-characterize the loan as a gift. This tends to be more of an issue when the amount borrowed is over $14,000. To avoid this situation, it’s advisable to charge an interest rate that’s at least the applicable federal rate (“AFR”), and then include the interest as income on your tax return. It’s also a good idea to establish your intent to collect. If the borrower never makes payments on the loan, the IRS may consider that as a sign that the loan was a gift.
Your accounting professional can help you navigate some of the pitfalls of lending money to a friend or family member.
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