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How To Properly Loan Money to Family, Friends

With 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 [3], 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.

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 [4]. 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 [5]).

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 [6])