A family loan is a financial debt a person owes to a relative. In the majority of cases, the agreement is extremely informal with no contract or interest, which can create problems with repayment. The line between borrowing and gifting sometimes becomes blurred, with some experts even recommending that the lender simply not expect his money back. From the tax perspective, the debt typically isn’t complicated, but the relationship strain it can cause is reason to approach this method with some caution.
How It Works
Under this type of lending agreement, a person goes to a relative for money instead of to a bank or similar company. The degree of blood relationship is not particularly important, but the relationship is usually close enough that both people feel comfortable working on financial issues together. In most cases, the agreement is very informal and not written down, with the borrower repaying without interest.
Reasons for Use
People often borrow from family members because it requires less work than going to a bank. Standard procedures financial companies use, such as checking a person’s credit, almost always are left out of the equation. Additionally, sometimes people want the money for something a bank might see as unnecessary, silly or too risky. Most relatives don’t charge interest, so getting money this way is often the cheapest option. Individuals also often look to family members when their credit is poor enough to eliminate more formal options.
A major problem with this type of debt is that the people involved often fail to spell out the terms for repayment in a concrete way. The lender assumes that, because the borrower is a relative, and because “life happens” to throw plans off, it’s not nice or necessary to strictly define how or when repayment will happen. In fact, the general motto usually is, “He’ll pay it when he can.” Similarly, the one receiving the money typically believes that it’s fine to make payments that are late or lower than planned because the relative giving the loan will “understand” difficulties or simply won’t care how or when he gets the funds back.
Taking this kind of approach to repayment can create additional financial and planning issues. The person who gets the money typically doesn’t include the loan repayments in his monthly budget, making it hard to be consistent. The individual providing the cash cannot commit it to anything in the future, because he cannot count on getting payments as expected.
Repayment is usually better when the borrower looks past his relationship to the lender and views him in the same light as a bank, credit union or similar business. He should be reasonably certain that he can stick to a payment plan and an agreed upon payment amount. If a person thinks he won't be able to meet his obligations, he might want to ask for a gift instead, or not ask for the money altogether.
Due to the problems a lack of a clearly defined repayment plan sometimes creates, experts recommend that people put a serious spin on family loans by creating a formal contract. This document doesn’t need to be especially complex; it just needs to outline basic terms and explain what consequences, if any, will be enforced if the money remains unpaid. The names of everyone involved and their contact information should be on the agreement, as should their signatures and the date of signing. Many websites have downloadable templates available if a person doesn’t want to create one from scratch.
A major advantage of using a contract with a family loan is that, if the lender has to sue in order to get his money back, there is a record of the obligation to pay. Judges use the document along with any payment records that might exist to come up with a judgment amount. Verbal agreements do have legal standing, but without hard evidence, the judge has to rely more on his gut or instincts, and the likelihood of the lender getting a favorable outcome goes down.
Assigning a Gift Label
For some people, it’s easier to consider the money a gift, rather than to worry about setting strict repayment conditions or working out a contract. With this method, the lender assumes that the borrower won’t pay on schedule, will pay in varying amounts or won’t give any of the cash back at all. This makes some sense considering that, unlike when a person goes through a bank, no loan insurance is available in these kinds of agreements. It also means that the lender only gives the money if he can afford to lose it.
In the US, a loan of less than $10,000 US Dollars (USD) does not have any tax obligations. A person can consider up to this amount per year a "gift" without paying gift taxes. The Internal Revenue Service only counts the interest earned as taxable income. Most people don’t need to worry about this, because unlike banks, relatives typically don’t bother to charge anything for the privilege of getting the cash.
When a family loan exceeds $10,000 USD, the situation can become less clear. To avoid paying a gift tax, people need to claim the money provided, but the IRS may assign the person an interest rate that they expect him to collect as "income." To avoid this, the lender may want to consult a good tax attorney or accountant to make sure the terms of the debt are clear, especially if no interest is being charged.
A lender also can claim unpaid amounts that will never be paid as a tax loss. Sometimes, the IRS will try to collect taxes from the borrower if the money technically becomes a gift due to nonpayment, however. This may be a more reasonable step than having to sue, but it's still a little complicated and may be best managed by a tax professional.
Failure to repay a debt of this kind can strain family relationships, even if those connections have been excellent in the past. The lender might feel offended and cheated if he doesn’t get his money, while the borrower typically doesn’t like being under financial watch. Conflict easily can spread to relatives not involved in the agreement, because they often feel obligated to defend one side or the other when problems come up.