Lending Money to Family Members and Friends

Added: September 27, 2006

People loan money to friends & family for very many reasons. Sometimes it is to help funding the purchase of the first car or home or to help face periods of unemployment or retirement situations.

Irrespective of the reason behind the loan some basic steps are to be followed while making any such loan.

Firstly, the person loaning the money should ascertain to reduce the loan to writing. Particularly the borrower should sign a promissory note to the lender. The promissory note should name the parties, spell out the amount loaned specify an annual percentage interest rate & the finance charge, lay out the procedures to be followed in case of payment evasion and list any property that is on security against the loan.

The interest rate specified on the promissory note should be ‘reasonable’. If it is not then the IRS may declare the loan invalid and the lender may have to incur a gift tax liability (assuming that the loan amount was for more than $12,000, which is the current annual gift tax exclusion amount). The IRS steps in incase of below market interest loans where the lender is deemed to have gifted the amount of interest to the borrower and the borrower is deemed as having paid the interest. It can lead the lender to reporting & paying income taxes on interest payments that they are deemed to have received.

In case of property held as security against a loan the lender should take steps to secure the property. Property securing procedures depend on the nature of the property and vary from state to state. While in some cases it is essential to take ownership of the property, in others it is adequate to file financing statements with the state or local or local government offices or simply to re-title possession of the property.

It may seem a bit awkward to ask for a security from a friend or family member but providing security for a loan proves beneficial for both parties. Say, the borrower suffers a financial slump & files bankruptcy before the loan is repaid, then the friend lender may be able to get paid before the borrower’s other unsecured creditors (such as the borrower’s credit card company).

Including procedural terms for the lender incase the borrower defaults on a payment increases the probability that the lender can deduct the loan as ‘bad debt’ if the borrower evades payment. The tax codes provide deductible personal ‘bad debts’ in the year when the loan becomes insignificant. The tax regulations state that it is not mandatory for the lender to take steps to impose a debt for it to be ‘worthless’; however it’s often hard to prove a loan worthless.
Lenders can include a condition in the promissory note that stipulates that the lender ahs to only send one letter to the borrower if the borrower evades one or more payments & that the borrower will have defaulted on the loan if he does not bring the debt current within few days. Lenders can then retain a copy of the letter (as a proof that they sent it) to ascertain that the debt was worthless & hence deductible.
These simple steps can prove beneficial in the long run for the both the parties involved even in situations of loan evasions.