mortagesandforeclosures

by Hunter Fisher

It is common for people to first turn to family members and relatives with their money problems. They do not usually charge high interest and impose difficult regulations like banks and lending establishments. No documents are also required for submission, and if they charge interest, it is often very low.

However, be cautious - it is still best to have the facts straight when loved ones ask you to lend them money. Some tax consequences may hurt you afterwards.

Charge interest, even when you think you shouldn't.

It is understandable why a lot of people are reluctant to require relatives to pay interest on loans. You don't want to seem unsympathetic to their situation. But take note that even if you decide to overlook the interest, the IRS will not. There is such a thing called "imputed interest." This basically means that the IRS will assume that since this is a loan, it naturally must have interest. And that interest is taxable income. If you don't charge interest then you will end up paying taxes on income that you really didn't earn.

A good guide for family loan interest rates is the applicable federal rate, or AFR. This is the minimum interest rate that the IRS uses for family loans, and depends on the Treasury bill rate.

Get It in Writing

Getting the details of the family loan in writing is another way to avoid problems with the IRS. First, you'll need to agree with the borrowing family member(s) that this really is a loan you're getting into. Then jot down the interest rates, payment schedules, and other terms you agree upon. You'll also need to make sure that the borrower is solvent -- that is, capable of paying back in time. Ask them to write a letter promising so.

If these things are not documented, IRS may consider the loan a present - and charge you gift taxes. Of course, as the moneylender -- you -- will be required to pay tax.

Do Away with Imputed Interest

Now if you want to steer clear of imputed interests and gift taxes, there is a way around these rules. You can get away with not charging interest and do not have to pay gift taxes as long as the loan does not exceed $12,000. Furthermore, the loan must not be used for income-generating purposes such as bonds or stocks.

The second option is the $100,000 exception. Under this rule, the loan that you extend to your relative must not exceed $100,000. If your relative earns an annual net investment income of $1,000 or less, you will not be charged by the IRS. If the net investment income exceeds this limit, the imputed interest is applicable only to the actual investment income earned.

Helping out a family member during financial hardship is not discouraged. But it is vital to be aware of the possible risks that you may face so you can make informed decisions about what to do with your money.

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