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How To Properly Loan Money to Family, Friends

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Kids With Birthday MoneyWith us firmly entrenched in a recession, the topic of loaning money to family and friends has really come to the forefront. With the holidays coming up, higher heating bills, and the potential of a layoffs (if they haven’t occurred already), turning to family and friends may be the last resort. If you can’t, or don’t want to, get a loan from a bank or through a peer to peer lending service like LendingClub, family and friends may be the only option for some.

This isn’t going to be an article about whether or not you should lend or borrow from family and friends, it’s generally undisputed as a bad idea financially for the lender. However, family is family and if you aren’t going to say “no,” then you might as well do it right. If you don’t, then you, as a lender, could get punished.

Set Terms & Sign A Contract

The main thing to remember is that you have to structure the transaction as if it were a loan. You have to set terms, such as loan amount, loan period, payment period, interest rate, and collateral. As long as you have a basic contract with all those details written, agreed upon, and signed, then the money will be considered a loan and not a gift. This is important because the annual gift limit is $12,000, with the giver of monies paying taxes on an excess; so if you give a $12,000 loan without documentation then it’ll be considered a gift and you will be taxed.

Applicable Federal Rates

There is only one rule about the loan you need to be aware of and that’s with the interest rate, it has to be above the Applicable Federal Rates, the minimum rates for loans between related parties. The applicable federal rate you must have depends on how long the loan is for.

  • Short term (< 3 years)
  • Mid-term (3 – 9 years)
  • Long term (9+ years)

The AFR is published each month and you can see an index of those rates at the IRS website index of Applicable Federal Rates rulings. For December 2008, the AFR for short-term annual compounding is 1.36%, mid-term is 2.85%, and long-term is 4.45% (PDF).

Interest Income

The final step is when you file your taxes, be sure to declare the interest income on your Form 1040 Schedule B and you’re all set.

Once you have all that, then the loan is considered a loan in the eyes of the IRS and you won’t have to fear the tax man declaring it a gift.

(Photo: theritters)

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9 Responses to “How To Properly Loan Money to Family, Friends”

  1. Cameron says:

    It’s pretty ridiculous I think that for a loan that I may want to give to my family or friends has to be above the applicable federal rates. Just another step in the process where they try to get your money.

  2. CK says:

    The proper way is don’t.

  3. Thank you so much for this article! I knew there were guidelines out there, had never seen them, but really appreciate that we’ve been handed tax-related reasons to put a family loan in writing that will minimize the awkwardness inherent in wanting a written contract. I also didn’t realize that the giver of a >$12K gift paid tax – I thought it was the recipient. Again, thanks.

  4. Donny Gamble says:

    Even though I think it is a bad idea to rent because you are simply wasting your money and not getting anything in return. Due to the circumstances of today’s economy, it might actually be beneficial to rent until the economy gets a little bit better.

  5. Jim says:

    Nice article Jim. I had no idea there were minimum interest rates for such loans.

  6. Marci says:

    And my personal fav rule: Never lend them more than you can afford to lose.

  7. Zane Austin says:

    Because fiscal responsibility isn’t taught in the home much, loaning money to family with all the correct documentation was at first very emotional for our kids. By the time they had reached 25 years old they “got it” that this is a loan and NOT a gift. Sucessful fiscal understanding became very clear from that point on. The “you owe me” attitude of our children disappeared though I had to garnish the wages of one son taking advantage of his family position.

  8. Jordan Daniels says:

    Hey Thanks! The article was really helpful. Didn’t know that loans between related parties needed to have interest rates above the federal level. Makes it good investment opp. for lenders though it could be a bit tough on the borrower. There are some great online websites that support inter family loans, most notable being LoanBack (www.loanback.com) which has great loan management and structuring tools for both lenders and borrowers as well as loan documentation and promissory notes to seal your contract.

  9. Shirley says:

    Jordan, thank you for the web address. I scanned it very quickly but it looks like it may have some good ideas that I can put to use.


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