I have a close family member who has had health problems this year and is facing high hospital bills. I would like to lend him the money. I know it is not always a good idea to lend money to family members. I wanted to get your opinion on what I should look out for in the future.
When a relative needs financial help, extending an intra-family loan may seem like a generous idea. However, if not properly executed, such loans can have significant negative tax consequences – such as unexpected taxable income, gift taxes, or both. Here are some things to consider in advance:
Create a paper trail
Make your intentions clear – and avoid any misunderstandings about the loan – by creating a written “note” and documenting the payments you receive.
In order to avoid undesirable tax consequences, you must generally prove that the loan was granted in good faith. To do this, you should provide evidence of the amount and terms of the debt, the interest charged, the fixed repayment schedules (if applicable), any collateral, repayment claims and the borrower’s solvency at the time the loan was granted and the payments received.
Show your intention to raise money
Even if you think you might get the loan forgiven at some point, make sure the borrower is making at least some payments. If you have some repayment history, the IRS will have a harder time arguing that the loan was actually a pure gift. And if a potential borrower has no realistic chance of repaying a loan – don’t take it out. If you get audited, the IRS will certainly treat such a loan as a gift.
Calculate interest if the loan exceeds $10,000
If you lend a relative more than $10,000, charge at least the prevailing federal interest rate (AFR). In any case, the interest on the loan is taxable income to you. If no interest is charged or interest is charged at a rate lower than the AFR, the taxable interest is calculated according to the complicated rules for loans with a below-market interest rate.
Take advantage of the annual gift tax allowance
If you want to help but don’t want to max out your lifetime estate and gift tax exemption, make the loan, charge interest, and then forgive the interest, principal, or both each year within the annual gift tax exemption. For 2024, you can forgive up to $18,000 per borrower ($36,000 if your spouse shares in the gift) without paying gift taxes or maxing out your lifetime exemption.
Forgive or sue
If an intra-family loan you were trying to collect is delinquent, don’t let it sit too long. To prove it was a legitimate loan that went sour (especially if you want to write off the unpaid loan as a loss on your tax return), you’ll need to take appropriate steps to collect it. If you know you’ll never collect it and can’t bring yourself to file suit, start working on forgiving the loan, using the annual gift exemption if possible.
Lending to family members can often be emotionally stressful, so take the time to ask a tax advisor for practical and specific advice if you and your family need it.
Crystal Faulkner is a CPA and certified professional EOS implementer who works with leadership teams to increase the value of their organizations. You can reach her at [email protected]. Tom Cooney is a CPA, CFP and Senior Financial Advisor at Wealth Dimensions, an investment advisory firm. Tom can be reached at 513 554-6000. You can hear Tom and Crystal daily on WMKV and WLHS on “BusinessWise,” a morning and afternoon radio show highlighting highly successful people, companies, organizations and issues in our area.
