Should you provide a Loan to a Family Member?

Should you provide a Loan to a Family Member?

Making loans to family members is fraught with danger and it can destroy relationships if not dealt with correctly. However, it can be a good planning move.

It is a common situation, even for young adults who are succeeding on their own, post-college: Asking if mom and dad can help out financially for a specific need, whether it's a down payment on a first house or helping pay off some lingering student loan. It is easy to have a misunderstanding of whether or not the money that was given was a loan or a gift. Also, if you were the one who gave the loan and the borrower does not make payments on a timely basis, you may find yourself frustrated every time they go on vacation or make a large purchase.  You may wonder why they are not making payments on your loan if they have enough money to do those things.

I have assisted many clients in arranging intra-family loans over the last 30 years. Intrafamily loans can be a popular way to take advantage of a low interest rate environment to shift wealth with a minimum of tax consequences for you or an heir and they can help your children to get ahead.

With an Intrafamily loan, parents can provide a financial resource to their children for a specific use. The key thing with the loan is to determine if the person is a good risk. You have the right to request a credit report on the borrower. You may find that they are not current with many of their bills and have a low credit score.

I'd be less inclined to recommend a client provide a loan to help a family member pay off credit card debt unless there's an extraneous reason, like a medical bill or job loss. 

Many of the most successful family loans I've been involved with are relating to the purchase of a home.  Often, young people can't quite afford the down payment on a home but they can afford the monthly payment and their credit score is good.

There are a few important guidelines to follow:

·     There needs to be a promissory note or other evidence of indebtedness. The loan has to be documented with a clear understanding of the interest rate, the terms of repayment. It's important to have the right supporting documents and terms in place for a true intra-family loan; otherwise, the IRS may treat the loan as a gift.

·     I recommend clients set the interest rate at a rate that is 3% higher than a 10 year Treasury note yield because there is a substantial risk of nonpayment.

·     If you want to offer a low interest rate to a family member, you should also know about the IRS Applicable Federal Rate (AFR). The IRS publishes an interest rate index called the AFR. These interest rates are determined by variety of economic factors and are used for various purposes under the IRS code including calculating imputed interest on below market loans between family members. When it comes to family loans above $10,000, the AFR represents the absolute minimum market rate of interest the lender should consider charging to prevent unnecessary tax complications.

·     Ideally, you will want to either get a book of checks already signed and dated for the different months for the cycle of the repayment or have them send automatic online payments to you.

You need to declare the interest income on the loan. This will help you to prove it was a valid loan if you ever need to challenge the borrower in court to make repayments.

While there are challenges here, depending on the goals involved, intrafamily loans can be an effective planning tool.

Call me at 201-650-0753 if you want to discuss this topic more and I can give you more insights.

Tim Watters, CFP  

Watters Financial Services, LLC