Before you borrow or lend within the family or clan, here’s what you should know

Is it a good idea to lend to a family or clan member?

Your family may be the most acceptable source of funding. Family loans can be an excellent bargain, especially for the borrower, but you’ve probably heard the adage: “Never lend money to a family member.”

These loans may have both financial and personal effects and tax implications. Before you take out a family loan, you should know a few things is you use BridgePayday.

What is the definition of a family loan?

A family loan, also known as an intra-family loan, is a loan made between members of the same family. Personal loans from traditional lenders or in the peer-to-peer (P2P) sector, which connects potential investors directly to borrowers, are frequently less formal than family loans.

On the other hand, family loans may have no contracts or simple contracts in which the borrower or lender keeps track of the amount of interest due and the payback dates. Although informal family loans may make sense for family relations, a loan is still a contract with tax implications for both the borrower and the lender: You must pay any interest earned by a lender back to the borrower in the form of taxes.

Things grow more problematic if the lender does not charge interest. According to the IRS, the lender must pay taxes on “imputed interest charges,” according to the IRS. Imputed interest is the amount of interest that the IRS believes the lender should have charged based on the facts.

If keeping track of interest, payments, and tax consequences sound like too much work, you might be able to hire a peer-to-peer loan administrator to handle the paperwork and collect payments on your behalf.

Advantages of family loans

  • Bad credit isn’t a problem: There’s nothing stopping family members from lending to one another, even if the borrower has a bad credit history.
  • Low-interest rates: Family members may lend to other family members at a cheaper interest rate than a bank.
  • Mutual advantages: The borrower may acquire a loan with better-than-average terms, and any interest is paid to a family member rather than a faceless lender.

The disadvantages of family loans

  • Tax implications: When dealing with a family loan, both the borrower and the lender must adhere to tax regulations. If they offer a below-market rate, lenders may be required to pay interest on both earned and unearned income. Borrowers may be required to repay the loan as agreed or claim the canceled debt as income unless an exception exists.
  • Credit history: Unless your loan payments are reported to the three major credit agencies, a loan from a family member is unlikely to boost your credit history.
  • Paperwork: If you’re giving a family loan, you might want to write out a contract that includes a guarantee to repay the debt. A promissory note is the name for this form of transaction. You may also wish to keep track of owing interest, payments, and other details.
  • Family dynamics: Will your brother fail to repay the $10,000 he owed you by summer mar Thanksgiving dinner? Loan arrangements that aren’t followed can lead to family strife.

When should I think about getting a family loan?

Loans made between relatives can be dangerous. Consider putting these requirements in place before any money is exchanged.

Usage restrictions: 

Down payment money from unsecured loans, such as family loans, aren’t always considered acceptable sources of funding for a mortgage down payment. If a family loan is being used to pay for a down payment on a house, you should think carefully (and double-check the terms).

Legal remedies: 

If a borrower defaults on a loan, the lender must choose between suing a family member or bearing the financial loss. If you can’t afford to lose the money, lending it might not be good.

Loan terms: 

The borrower and lender should agree on a repayment plan and an interest rate before making a loan. A signed contract should include the loan details.

Tips on how to make a family loan tax-deductible

Even though a handshake between family members is an enforceable loan contract, the IRS considers money transfers between family members to be gifts unless the lender expected to execute the payback obligations. Follow these procedures to guarantee that your loan is legitimate in the eyes of the law.

Keep track of everything.

The paperwork does not end once the loan is approved. Both the borrower and the lender should maintain track of payments and the loan balance. Taxes will benefit from good recordkeeping, as will keeping family members on the same page.

Gifts and loans have their own set of tax restrictions. If you’re concerned about the tax implications of a family loan, it’s a good idea to seek advice from a tax professional.

Charge interest

The relevant federal rate is a minimum interest rate set by the IRS. For loans over $10,000, the relevant federal rate is the lowest interest rate a lender can charge a borrower. If the lender charges a lower rate than the applicable federal rate (for a loan exceeding $10,000), the lender will be required to pay taxes on the interest that was not paid.

Forgone interest is the interest that a lender would have earned if the applicable federal rate had been charged, less any interest that was actually paid on the loan during the period. The minimum interest rate varies depending on whether the loan is for a short term (three years or less), a midterm (three years to nine years), or a long term (more than nine years).

The yearly applicable federal rate for a short-term loan was 0.14 percent in January 2021. 

If a lender does not charge at least the applicable federal rate, the unearned interest may be subject to taxation.

Consider a written agreement

While a handshake theoretically constitutes an enforceable loan contract, putting the repayment requirements in writing provides evidence that the lender intends to enforce the debt repayment obligations.

Agree on a repayment plan.

If the loan arrangement does not include repayment terms, the rules regarding loans between family members might get difficult. Setting a payback schedule for loans between family members is a good idea. The borrower can make monthly payments or repay the loan over several years.

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