Sometimes clients tell me they’ve either loaned money to their children or their children have loaned money to them. As an attorney, I lean toward having these commitments reduced to writing so everyone is clear and there are no surprises. Of course, the decision to put the agreement in writing is ultimately left up to the clients, but there are several issues to consider with any family loan.
First, regardless of whether its written down, family members should still be charged interest. If you charge below the rate, or make an interest-free loan, the IRS may impute the difference as interest earned and consider it taxable income. In some cases, the IRS could characterize the entire loan as a gift, subject to gift tax.
An acceptable interest rate for the IRS is the “Applicable Federal Rate” or AFR. You can check out those rates by following this link. The imputed interest rules don’t apply to loans of less than $10,000. You can read much more about related-party transactions and the below-market interest rules in IRS Publication 550 at the IRS website.
Second, the promissory note should include all of the following elements:
- The loan amount.
- A definite payment date or dates.
- A stated rate of interest.
- Collateral or security.
Third, you might consider taking the awkward moments out of a family loan by having a third party administer it. For a $99 fee, Virgin Money formalizes the agreement you and takes care of the paperwork. For $199 plus $9 per payment, they’ll also electronically collect payments from the borrower’s bank account and credit yours. For $14.95, LoanBack will generate a promissory note and pay schedule, but won’t help you collect.
Fourth, from an estate planning standpoint, it is much better to put these agreements in writing to provide a paper trail for the executor or trustee to piece together who owes what and to whom.
Hope this helps.