What to Know About Friends and Family Loans

Blog posted On June 19, 2019

Lending money to friends and family, when you are financially able, can be a good way to help someone out and can also be a tricky subject depending on the outcome.  Children may borrow money from parents to attend college or buy a car, siblings may borrow money from each other to pay for an unexpected healthcare cost, and a friend may borrow money to start a business.  If you are considering lending money to a friend or relative there are ways to help them out and still protect yourself.  

Here’s how to avoid tax consequences making a personal loan to friends or family:

Setting the interest rate

Your friend or family member is likely coming to you for a loan because they are expecting a lower interest rate than a personal loan from a bank or lender.  A “below-market” interest rate means the lender charges either no interest rate or a rate below the applicable federal rate (AFR).  AFRs are the minimum interest rate you can charge on the loan without creating tax side effects for yourself.  AFRs are dictated by the government and may change from month to month.  Depending on the circumstance, you may want to charge an AFR rather than a 0% interest rate.  The borrower will still get a better interest rate than if they worked with a bank or lender and you won’t have tax complications later on. 

Rates for term loans

Will this loan have a specified repayment date?  If you issue a loan with set terms, the same AFR will apply through the life of the loan, and not change from month to month.  For example, if you issue your son a loan in May of 2019, the AFR would be 2.35% for the next five years.

Rates for demand loans

The other type of loan is a “demand loan” that you as the lender can call due at any time.  In this case, the AFR for each year will be a composite rate that reflects the changes each month.  With a demand loan, you may collect significantly more or less interest depending on market rates and how long the borrower has the loan.  This type of loan can lead to more uncertainty and awkwardness between you and the borrower, and most lenders avoid this when possible. 

Tax rules for below-market loans

Issuing a loan with an interest rate equal to or above the AFR relieves you of any tax complications down the road.  However, if you choose to issue the loan with no interest rate or an interest rate below the AFR, there are certain tax rules that you need to know about.  

MarketWatch contributor Bill Bischoff wrote, “When you make a below-market loan (one that charges an interest rate below the AFR) to a relative or friend, our beloved Internal Revenue Code treats you as making an imputed gift to the borrower. The imaginary gift equals the difference between the AFR interest you “should have” charged and the interest you actually charged, if any. The borrower is then deemed to pay these phantom dollars back to you as imputed interest income. Although this is all fictional, you must still report the imputed interest as taxable income on your Form 1040. The resulting extra federal income tax hit is not fictional.” 

What to get in writing

Even family and friend loans can go sour depending on unforeseen circumstances.  Getting everything in writing ahead of time, protects you from financial consequences and awkwardness down the road.  Your loan should be evidenced in a “written promissory note” that should include:

• The interest rate
• A repayment schedule including the amounts for interest and principal payments
• Any security or collateral for the loan 

Before agreeing to issue a loan to a friend or family member, talk with a financial planner or tax advisor.  Avoid tax complications and get everything documented to protect you and the borrower.  In the end, it might even be better for the borrower to take out a loan elsewhere, depending on how they will be using the funds. 

Sources: MarketWatch