Should I Lend Money to Friends and Family?

Lending money to a loved one can be a sticky situation, and we’re not just talking about how it will impact your relationship. If you choose to give someone close to you a loan and don’t do it the right way, the IRS can swoop in and make your life miserable. Below are some tips for giving a loan the tax-smart way.

IRS Guidelines on Personal Lending

The Internal Revenue Service (IRS) can and will get involved if you loan money to family or friends, particularly if it’s interest-free or reaches a certain dollar threshold. The IRS has the power to “re-characterize undocumented, no-interest loans as taxable gifts.” This could potentially trigger “gift taxes,” which may require you to report interest income, especially for loans over $10,000.

Avoiding IRS Issues

Helping friends and family out of a financial bind is almost always done with the best of intentions. We want to help others when we can; that’s just part of the human experience. If you can help and want to loan money to a loved one, make sure you do it the right way to avoid tax implications or other penalties. Here’s how to help and avoid unnecessary IRS scrutiny:

Charge Interest

It’s a mistake to give someone a loan with no interest. If you do, you may be faced with complicated tax rules down the road. A better idea is to charge them the IRS-approved applicable federal rate (AFR). The good news is that AFRs are really low right now. The AFR for a “mid-term” loan—one for more than three years but less than nine—is only 1.53%. 

Choose a Loan Type

There are really two distinct loan types when lending to a friend or family member, and they are as follows:

• Demand Loan. A loan type that allows you to ask for repayment at any time. This is somewhat less favorable for the borrower. The AFR is not fixed, so you’ll have to charge a floating AFR based on constantly changing short-term AFR rates.
• Term Loan. If you use a term loan, repayment is on a fixed schedule for the term of the loan. Plus, you’ll be able to lock down a low interest rate for the duration of the loan term.

Make it Formal

It is a formality and may seem like overkill, but put the loan in writing. This protects you and your loved one. It’s not only so you get paid, but also so the IRS knows it’s a loan, not a gift.

• Document the loan. Write up a “promissory note” that outlines the following:
  • Interest rate (AFR). The amount you’re charging for the loan.
  • Maturity date. The final date for repaying the loan.
  • Repayment schedule. Lists how much and when payments are due.

• Document payments. Make sure to write down the payments made and that you’re getting at least semi-annual payments to show the IRS that you’re doing your best to make your money back.

Do One Thing: Be careful before lending money to loved ones. If you do, make sure you do it right to protect yourself and your loved one.

This information is provided for educational purposes only. It is not intended, nor is it to be used as, tax, financial, or legal advice. For guidance and advice regarding your personal situation, contact a licensed financial, tax, or legal professional.