Family Loans - Hilton Head Monthly, June 2009
Tough financial times can cause stress within families. According to a recent poll by Paypal, 10% of respondents said the role of the primary breadwinner has shifted in the last 6 months due to salary reductions or job layoffs. Money now outranks sex as a source of marital conflict by a 2 to 1 margin.
Many adult children, affected by troubles in the job or real estate market or seeking to support a struggling business, look to their family, usually a parent, for financial help. Sometimes these are very short term loans, but often the amounts or the time frame needed are much more substantial. The World Bank estimates that informal gifts and loans between family members total more than $300 billion worldwide.
The challenge for both family lenders and borrowers is to ensure that these arrangements don’t turn into a source of conflict and discord. All parties to every family loan start out with good intentions; however, the sad fact is that roughly 14% of loans between family members end in default, compared with less than 3% of ordinary consumer bank loans, according to Money Magazine. Here are some general guidelines.
First. Consider your own circumstances
If a family member asks for a loan, stop and take a deep breath before you answer. If it’s not a dire emergency, take the time to review your own finances to be sure you can really afford the loan. A substantial loan might impact your ability to withdraw income from your portfolio for a period of time. Consider what would happen if the loan was not repaid. Although the natural reaction of a parent to a child in trouble is to help no matter what, with adult kids that response should be tempered by some distance and objectivity. Is their definition of an emergency really the same as yours? Loans to bail kids out of foreclosure can be tricky, especially if the house was too much to begin with. Loans to support business enterprises also have a high default rate.
Second. Get it in writing.
Document the loan as to amount, payment terms and collateral, if any. If you are the lender be clear that you expect to be paid back over an agreed upon schedule. If you are uncomfortable with this you can go to any number of third party services such as “Virgin Money” that will arrange details of a family to family loan for a fee ( www.virginmoneyus.com).
Third. Charge interest.
Yes, we know you don’t want to but if you don’t set an interest rate the IRS will set one for you. The IRS establishes what is known as the Applicable Federal Rate to apply, among other things, to loans where no interest is charged. From the IRS point of view a loan implies interest income for the lender, and the possibility of taxes due on this interest, even between family members. This is known as imputed interest.
There are some exceptions. Imputed interest on otherwise interest free loans is not taxed if the balance of all loans between the two parties is $10,000 or less.
If the balance of all loans is over $10,000 but under $100,000, the amount of taxable imputed interest is zero, as long as the borrowers total net investment income for the year is less than $1,000. If the borrower’s income is greater than $1,000, imputed interest is limited to the actual amount of investment income. For example, you lend your child $50,000 interest free, but the IRS imputes a 5% interest rate. You will have to declare $2,500 of imputed interest. However, as long as your child’s total interest income is less than $1,000 you won’t have to pay taxes on the income. If your child’s interest income is $2,000, you would only have to pay taxes on $2,000 rather than the full $2,500.
Fourth. What if they can’t pay?
Consider this carefully before you agree to the loan. An unpaid debt between family members can exacerbate the original financial issues and cause emotional problems as well. It can add to the stress between your child and their spouse, and make family visits and holidays awkward and uncomfortable occasions. Collateral is important but consider; would you really be willing to foreclose on your son or daughter? If you try to write off a bad family debt, the IRS can choose to go after the taxes you would have paid on the interest. They would look to collect these from the defaulting party, that is, your child.
Some loans to children just never get repaid, and become a kind of inheritance in advance. This can be fine, so long as you are prepared for this, and are willing to make some equalization in your will or trust so that all siblings are treated equally. Remember, there are no secrets in a family, so assume that all children know everything about all the help you have given each of them, and be sure wills, trusts and IRA beneficiary designations are set up in such a way that all kids really inherit equally, if that is your intent. Otherwise, your good intentions to help your children financially may lead your family down the path of discord and conflict.