Loaning money to a relative may not seem like a good idea. However, under the right circumstances, it can be a positive and profitable experience for you and your relative. For example, your savings may be earning very low interest in a bank CD or savings account. Meanwhile, your niece may need to borrow money for a car. You can lend her money at a lower rate than she can get elsewhere and still improve your return significantly.
In my experience, I have seen children borrow money from their parents to remodel or expand a house. By structuring the loan correctly, both sides benefit from the arrangement. The children pay a below-market interest rate and avoid points and other fees, while the parents increase their investment return.
Everyone has heard stories of loans between family members that do not get repaid and cause issues within the family. To avoid these problems, you should follow some practical rules:
Rule #1: Formalize the loan by putting it in writing. Having a formal loan note can prevent disagreements and squabbles over terms. An agreement can also be used as evidence if the IRS ever questions the arrangement. The note should clearly state the amount, the interest rate, the terms of repayment, and the collateral, if any. If the loan involves real estate, you should consult an attorney to make sure the loan is properly structured and recorded.
Rule #2: Watch out for tax traps when you set the interest rate. Generally, you can charge any interest you want on loan amounts below $10,000 (even zero interest). Above that amount, there are IRS rules that may affect the minimum interest rate you can charge. Make sure to check with your tax advisor so you don’t get hit with penalties in this area.
Rule #3: Although a family loan has personal attachment, it is a business transaction, so do not be swayed by emotion. Make the loan only if you can afford to be without the money, and DON’T make the loan unless you have realistic expectations about getting paid back.
No amount of money is worth a ruined relationship with a family member but you can partake in a win-win situation with a family loan if you set-up both parties to be successful. Check with your tax advisor before you endeavor in a loan arrangement with a family member. They can help guide you through the process.
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