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Making a loan to friends or family members means risking not just the loss of money, but of close relationships with your loved ones. At times, however, a loved one needs financial help and you can — and want to — provide it. Keep these caveats in mind to limit the risk, both to your bank account and to your relationship with the borrower:
Never lend more than you can afford to lose. Even the most trustworthy borrowers can run into difficulties, such as an illness or divorce, that hamper their ability to repay the money.
Find out how the money will be used. Like any lender, you have a right to know what the borrower plans to do with the funds. Be especially cautious if the borrower is requesting money to pay for groceries, rent or other ongoing expenses. Discuss the steps he or she is taking to obtain the money to repay you. For instance, has the borrower started a second job or moved to a less expensive place?
Put the terms of the loan in writing. This should include the loan amount, the use of the funds, the repayment schedule and the interest rate, as well as the actions you’ll take if the borrower doesn’t repay the loan on time. Documenting the terms of the loan reduces the risk of disagreements. It also helps indicate the transaction wasn’t a gift masquerading as a loan — a distinction that’s critical to the IRS, as noted below.
Insist repayments be made via a method that can be tracked. Repayments can be made by check or through a service like PayPal. This reduces the likelihood of disagreements about the portion of the loan that’s been repaid.
Pay attention to potential tax implications. The IRS may view the loan as an attempt to get around gift tax regulations. They tend to be most concerned when the amount borrowed tops $10,000, or less than that if the money is used to purchase investments. On this type of loan, you’ll typically want to charge an interest rate that’s at least the applicable federal rate (AFR), and then include the interest as income on your tax return. It’s also prudent to demonstrate an intention to collect. If the borrower never makes payments, the IRS may view that as an indication the loan was a gift.
Your accounting professional can help you determine whether it makes sense to lend money to a friend or family member. He or she also can help you identify and comply with any applicable tax regulations.