Avoid Tax Traps with Loans to Friends and Family
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Avoid Tax Traps with Loans to Friends and Family

06 Sep Avoid Tax Traps with Loans to Friends and Family

Posted at 15:37h in Your Income by

Lending to friends and relatives can be tricky, and not only because of the stress it can place on your relationships. There are tax issues involved as well. If you have to lend money to someone close to you, here are some tips to do it right in the eyes of the tax code.

Charge interest

Yes, you should charge interest, even to friends and family. If you don’t charge a minimum rate, the IRS will imply interest in the loan and tax you for the interest income they assume you should be getting. This can occur even if you’re not actually getting a dime.

Charge enough interest

Not only should you charge interest, the amount must be reasonable in the eyes of the IRS. If it’s not, the IRS will imply interest at their minimum applicable federal rates (AFRs). To stay on the safe side, always charge the interest rate at or above these AFRs, available on the IRS website. The good news is these interest rates are low and almost always below the prime interest rate.

Know the exceptions

If you don’t want to charge interest, you don’t have to IF:

  • The money is a gift. In 2021, you and your spouse can each give up to $15,000 to an individual each year.

OR:

  • The loan is less than $10,000 and is not used to purchase income-producing property.

If you don’t charge interest and the loan is used to purchase income-producing property such as capital equipment or to acquire a business, special tax rules apply. In this case it’s good to ask for assistance.

Get it in writing

If you expect repayment, write out the terms of your loan. There are a variety of basic loan document formats online that you can use. Creating a loan document may seem unnecessarily formal when dealing with a friend or family member, but it’s important for two reasons:

  1. Document your tax code compliance. By documenting the terms and charging a stated interest rate, you can clearly show you are within tax code rules.
  2. Avoid misunderstandings. Creating a written document will make it clear that it is a real loan, not an informal gift. Your friend or relative will know that you expect to be paid back and when you expect repayment.