Thinking of taking a new loan? Wondering where you can find the best possible terms? The truth is that so-called ‘family loans’ may be the best option to get away with minimal or no interest charges; however, these types of loans are notorious for causing complications with those closest to you. It is important to carefully weigh the risks and benefits before committing to any loans, especially those with family members. This article will introduce the advantages and disadvantages of family loans and discuss ways to minimize complications.
First, it is very important to properly document the transaction as actual loan. This involves taking down the terms of payment along with any assets pledged as securities to back the loan. This will help prevent complications later when it comes to justifying the position to the IRS. Moreover, this will make income taxes much easier for your lender. There are two ways to approach the documentation process: (1) approach a lawyer to draw up the documentation or (2) simply do it yourself. Some of the most convenient options available can be found online in family legal software which provide templates for a number of situations. A properly documented loan can not only help resolve any disputes as to the numbers between family members but also keeps things legal with the IRS.
The IRS imposes several restrictions on family loans. It is important to specify that the loan is not a gift and that the lender is expecting you to return the money within a particular time period. Any interest payments received by the lender are considered income and are taxable by the IRS. If interest is not charged the IRS can still levy a tax on the interest that should be being charged. This complicated “imputed tax” basically means that if this is truly a loan, and not just a gift, there should be interest payments – and the IRS is going to tax the lender for these interest payments whether or not he is actually receiving them.
One of the other major tax implications to consider involves loans going towards mortgages. After all, one of the most common types of family loans is a loan to finance the down payment on a house. It is best to secure this note with your new house as it will help you take advantage of a whole range of tax deductions later, as interest payments are deductible. Additionally, trying to hide the source of income for your down payment could get you into major trouble with the authorities. Consequently, it is extremely important to bring this issue up when applying for a home mortgage.
Entanglement with the IRS’ crazy imputed interest can generally be avoided if the total loan amount of the loans between the two parties is less than $100,000. To explain, the $100,000 rule comes into play when the cumulative balance of all the loans between the concerned parties, including interest, is less than $100,000. This rule allows the imputed interest to be zero for the purposes of income tax if the borrower’s net income from investments within the given year is not more than $1,000. In almost all cases of family loans, the person borrowing the money is probably lacking significant investment income – so the lender should be safe from imputed interest tax.
In the end, it is often advisable to contact a tax lawyer before you enter into a large family loan because the tax implications can be complicated. You can avoid all the above hassles by simply legitimately charging interest on the loan that you give because and declaring the interest as taxable income.
Though in all this talk about tax troubles, we haven’t really taken the family relationship into account yet, but bad family debts can significantly impair if not ruin family relations. Carefully consider what each person is getting into before rushing into a family loan, and if you decide to go through with it draw up proper papers and keep your business and personal relationship distinct. There have been countless instances of families being torn apart over a good-natured loan – don’t become one of them.