The recession made many parents and grandparents into personal bankers, making loans to strapped children or grandchildren to help them cope with unemployment or other financial misfortune.
However, family loans need to be prepared properly to avoid tax repercussions. Here are some tips on how to do that:
Put loan terms in writing – the IRS says a loan is a loan, and requires that family loans be put in writing with clear terms and a repayment schedule.
Use fair market interest rate— for loans of more than $10,000, you must set a fair market value interest rate or the IRS may consider it a gift instead of a loan. That interest rate must be at least as high as the minimum monthly interest rates set by the IRS. However, because you are allowed to give gifts of up to $14,000 per year tax-free, you can forgive up to $14,000 annually in payments.
Obey tax laws – the loan must be properly structured if the borrower plans to deduct the interest. Depending on how much the loan is, a lender may need to pay income taxes on the interest earned. However, if the family member does not pay you back, you may be able to take a deduction for a nonbusiness bad debt.
Plan for contingencies – you should plan for certain contingencies; i.e., if the loan will be forgiven in the event the borrower or lender passes away before it is paid off. Be sure to talk about estate planning issues with a qualified estate planning attorney.