Smart Ways to Loan Money to Family Members

Whether you’re lending money to your college-bound child or your entrepreneurial brother-in-law, treat the loan as a business transaction. That will increase the likelihood that you’ll be repaid and keep the IRS at bay.

But first, think hard about whether you can afford to lend the money. “It’s an investment,” says Curtis Arnold, founder of CardRatings.com and coauthor of The Complete Idiot’s Guide to Person-to-Person Lending. “You can lose the whole kit and caboodle.”

Still, a direct loan is less risky than cosigning a loan, says Gerri Detweiler, director of consumer education for Credit.com. If you cosign, you’re on the hook if the borrower defaults -- and you may not know about it until your credit rating takes a tumble.

If a family member asks you for a loan, start by asking why he or she needs the money. A loan that would help with college tuition or the purchase of a home could improve the borrower’s financial security. Similarly, a loan could help a relative recovering from a financial setback to avoid predatory lenders, Detweiler says. Conversely, lending money to a family member who has a history of poor financial choices could enable more bad behavior. Ask the potential borrower to provide you with a copy of a credit report and score. The score probably isn’t stellar, or the family member wouldn’t be hitting you up for a loan. But a credit report (the prospective borrower can get one free at www.annualcreditreport.com) will give you an idea of the individual’s other financial obligations.

How much to charge. If the borrower is really struggling, you may be tempted to make a no-interest loan, or charge a nominal amount. Be aware, though, that doing so could get you into hot water with the IRS. To avoid having the transaction treated as a gift, the IRS requires that you charge at least the applicable federal rate (AFR), which is published monthly at www.irs.gov. Otherwise, the IRS could dun you for taxes on “imputed” interest income, based on the AFR when the loan was made. You’re not required to charge interest if the loan is for less than $10,000, or up to $100,000 if the borrower’s investment income for the year is less than $1,000.

Federal rates this year have ranged from about 0.21% to 3.28%, depending on the length of the loan. Of course, you’re expected to report interest you receive as taxable income.

If you wind up forgiving the loan, you might be entangled by gift-tax rules. Gifts that exceed $14,000, including any unpaid interest, require that you file a gift-tax return and cut into your lifetime gift- and estate-tax exemptions.

Put it in writing. In addition to charging interest, drawing up a formal agreement will make it clear to the IRS that you’re making a loan, not a gift. It’s also a good way to ensure that everyone involved understands the terms of the loan. You can find sample promissory notes online, and Web sites such as www.bankrate.com provide tools that will calculate monthly payments.

Arnold, who has made several loans to friends and family members, uses LoanBack, which sells a personalized loan agreement you can track online. A product that will calculate payments and provide e-mail alerts costs $29.95; a basic downloadable template (that doesn’t do the math for you) is available for $14.95.