Carefully Structure Family Loans To Avoid Unintended Consequences

Family loans could be effective in many situations, but families have to be sure to consider tax and relationship implications. The main consideration is to be sure to structure and document the loans properly. If you don’t, then you could end up with unintended gift and income taxes. If you don’t have a high enough interest rate on the loan, then the IRS views the “forgiven interest” as a gift and that will eat into your annual gift tax exclusion and possibly your lifetime exclusion.

Proper structure and documentation involves several steps. Below are several of the steps that The Street mentions:

• Properly record with the right governmental authority
• A promissory or mortgage note should have an interest rate equal or greater than AFR. It should also spell out terms and payment dates.
• If you properly record and document a mortgage, then you can list the interest as income on Schedule B of your return and deduct mortgage interest expense.

Other things you want to consider include whether the borrower will pay you back, whether you will start a precedent that will lead to other family members asking for loans, and how the family relationship is.  

See Michael Maye, Watch Out for Implications of Family Loans, The Street, Nov. 27, 2011. 

Special thanks to Jim Hillhouse (Professional Legal Marketing  (PLM, Inc.)) for bringing this article to my attention.