Loaning money to family is tricky. There’s a minefield of complications that can be set off with one step in the wrong direction.
Our own government is a perfect example. We’ve got a hefty debt, and we’ve borrowed A LOT from other nations to subsidize our shortfall (and mismanagement, often).
Now it looks like we could be defaulting on our loans if Congress doesn’t come to a consensus soon. (Not likely, but you get where I’m going with this.) That could mean T-R-O-U-B-L-E for global financial markets and even greater questions about our credibility as “trustworthy borrowers.”
The definition of “trustworthy borrower” is a separate conversation, but for you, the consequences of someone defaulting on a loan you give them are obviously not as serious as widespread unemployment. But it doesn’t mean that there aren’t repercussions for you.
Even if the person is a good bet and certain to pay you back, you need to know what it means for your taxes when you start lending. I’ll get into that below, but if you want to sit down and discuss this situation more, find me here:
Here are my thoughts on the tax implications of loaning money to your Orange County, California nearest and dearest…
Consider This When Loaning Money to Family or Orange County, California Friends
“Loan oft loses both itself and friend.” – Shakespeare
If you’ve done well for yourself, then sooner or later — either because they ask for the money or because you want to offer it — you’re going to be in a position to lend to a friend or family member.
Should you or shouldn’t you? Often somebody you know will need a loan for a valid reason, such as an emergency outlay. Maybe they don’t have the credit history yet to qualify for a third-party loan or a line of credit, or they just lost their job in an otherwise good history of employment.
Maybe — and be careful of this one — you feel guilty that you’re not the one in need and you just want to offer a hand up.
We can’t address your emotional debate concerning loaning money to family or friends, but we can give insight concerning the tax implications of opening your wallet wide for someone close to you.
Loaning money to family or friends: Does it work out?
Well… not always. Take this related scenario: More than half of people recently surveyed said springing for a group experience and expecting to get paid back did not end well. It’s the same sort of thing when it comes to loaning out a sizable amount of cash to a friend. In more informal and emotional financial arrangements, the closer the borrower is to you, the less well it could end.
But regarding taxes: A “gift” is one thing, a “loan” another. Taxes on gifts are controlled by the gift tax and its exemption. This year, you can give up to 17 grand (per recipient) to someone before having to pay tax. (This amount has increased about 1,000 dollars a year over the past decade). Any gift tax that you, the donor, pay over the cap cannot be deducted on your income tax return.
You also might need to think about how the gift tax works if the loan doesn’t come off as planned… since what is lent becomes a “gift” if it isn’t repaid.
Loaning money to family or friends: Making this official
Whenever noticeable amounts of money change hands, it’s smart to get something in writing — in this case, a loan contract or agreement.
Your contract, which you and the borrower sign, should include your names, the amount and date of the loan, the minimum regular re-payment, payment frequency, and the dates when each payment is due as well as the legal consequences (if any) for defaulting. It’s a good idea to consult professional guidance as you draft your contract. We can help with this if you’d like some.
Here’s a question: Should you charge interest? Doing so kicks the loan clear of any possible “gift” category for tax purposes (more on this in a second) and conveys to both parties — especially the borrower — a business-like nature of the arrangement. Some points (so to speak):
- You can’t go far wrong with the Federal Reserve’s rates, right now starting at almost 5%. That percentage is also in line with the IRS Applicable Federal Rates. You don’t want to lend at rates lower than that, or Uncle Sam might consider the money as a gift.
- If you have ideas about teaching the borrower a money lesson by charging high interest, bear in mind that usury laws limit what you can charge.
- Interest on loans greater than 10 grand is considered income to you for tax purposes; you have to pay tax on the foregone interest if you charged a ridiculously lower interest rate, too.
- And if the loan isn’t repaid, you have to report it as a gift and potentially deal with the gift tax.
Loaning money to family or friends: Other options to consider
Cosigning. You might think putting your name alongside theirs on third-party financing is less risky than outright lending cash to friends or family. But you can find yourself with equal legal responsibility for the debt if the borrower defaults. A cosigned debt gone south can also hurt your credit score. Just some things to keep in mind.
Collateral. This is a potential bookkeeping snarl but, much like interest, the formality of asking for collateral gives the loan a business-like feel. Make sure the value of the collateral comes close to the value of the loan. Spell out the terms in your contract.
Indirect loan. This gift goes elsewhere to free up the borrower’s own money. An example would be contributing to a family member’s individual retirement account if they have earned income and mean to contribute but can’t afford to.
Don’t lend what you can’t afford to lose… no matter how you feel about the borrower. And, obviously, lend only to those you trust.
Lending money to family or Orange County, California friends can be a more complicated and emotional decision than strictly business loans. Of course, it doesn’t always end in disaster. I just want you to feel permission to think on it and be wise with how you do it (if you choose to lend out your money) — rather than feeling obligated to lend and having it come back to bite you later.
Let us know if you want to talk it through,