How To Lend Money To A Family Member...

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Lending money to family member can be tricky enough—the last thing you want is trouble with the IRS. Keep your relationship with your family and the IRS intact with these simple steps.

With the economy hurting and the job market weak, you may want to help a family member with a loan. But your helping hand could help land you in hot water with the IRS. Follow these five steps to ensure your generosity doesn’t end up costing you.

  1. Charge interest. To avoid tax law consequences, you must charge interest if you’re lending more than $10,000. (And with interest rates so low, you may want charge interest no matter the dollar amount just to avoid any scrutiny.) The rate you charge should be at least the same as the IRS’s applicable federal rate (AFR). AFRs are updated and published monthly.
  2. Agree to a loan and payment structure. A balloon loan is set for a certain time period (say, 10 years) with regular small interest payments and a larger final payout. An installment loan also has a set time period, with monthly principal and interest payments that will pay off the loan by the end of the loan period. Both these loans are considered term loans. To calculate the interest on these loans, use the AFR of the month you made the loan. This rate can be used for the entire loan term. You can also set up a demand loan, which must be paid back at any time when demanded. This gets more complicated, however, as the interest rate cannot be fixed and must be calculated each month of the loan as the AFR rate changes.
  3. Put it in writing. No matter how big or small the loan, or how trustworthy the family member, put the loan in writing. And when you do, be specific. Write down the total amount of the loan—dollars and cents. Include the specific date (not a general period in time) that the loan will be repaid. State when principal and interest payments are due. Having everything on paper lends credence to your loan and is more likely to be respected by the IRS as a loan rather than a gift. Find easy-to-use loan contracts at Nolo.com.
  4. Collect payments. While it may seem altruistic to let interest payments on your loan slide, your best bet is to collect these payments on a regular basis. This doesn’t need to be monthly, but should be at least semi-annually. And be sure to collect the principal payments as they are due. If you wish to convert your loan into a gift at some point, you can give up to $13,000 a year to an individual without gift tax consequences.
  5. Report the interest income. You must report all interest income you receive from the loan on your yearly taxes—whether you collect that interest or not. As for the family member receiving the loan—they can deduct the interest from their taxes if the loan is secured with their home.

While you can set up and manage a loan to a family member on your own, there are professionals available to help you. Consider talking with a tax advisor, lawyer or accountant, especially if the loan is large or the time period is extensive.

This article contains general information. Individual financial situations are unique; please, consult your financial advisor or tax attorney before utilizing any of the information contained in this article.

Source: SmartMoney.com, Forbes.com
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