How to Protect Your Relationships and Your Investment
Shakespeare was onto something when he wrote, “Neither a borrower nor a lender be.” Rather than trying to encourage the world to be tight-fisted with their cash, he was likely alluding to the idea that lending money to friends or family can be a touchy situation.
It’s natural to want to help a friend or family member when they need financial assistance, say experts at the Pennsylvania Institute of Certified Public Accountants (PICPA). But be careful. Money can drive a wedge into friendships and family relationships. There are tax-related considerations, too.
Here are some considerations before you commit to lending money: steps you should take, not only to ensure everyone understands the details of the loan, but also to reduce the likelihood of breaking a tax law.
Think It through Completely
Lend only what you can.
Before you lend anyone money, you need to evaluate your own situation. Can you afford it? Do not lend more than you can afford to lose.
Don’t take from your future.
If you do not have cash on hand to make the loan, do not take the funds from your own retirement accounts.
Who else will be affected by your decision? If you have a significant other, discuss the request with him or her.
What is the money for? Money to cover an emergency car repair may affect your decision-making process differently than money for a risky investment scheme or a beach vacation.
Your loan may be to a friend or family member, but treat it like a business arrangement. Agree on the loan amount, terms, interest rate, payment schedule, and any penalties for late or missed payments. Determine what will happen if the borrower defaults.
Write it down.
Perhaps the most important step of all is creating a formal contract. Writing it down will help make everyone more accountable.
Have a witness to the loan.
Have the document signed and dated by you and the person you are lending the money to. Have the document notarized or at least have a third person sign off on it.
Don’t be afraid to say no.
While helping your family and friends is a lovely idea in theory, someone who repeatedly needs money because of bad decisions and poor money management will not be further helped if you throw good money after bad. The greatest gift may be the gift of financial planning services. Keep in mind that there is a reason the person is asking you for a loan instead of a lending institution or someone else.
Once you have given the loan, acknowledge that you have no control. Don’t obsess over how the money is spent. Just follow the terms of the loan, or you may find yourself angry and resentful.
Co-signing on a loan as opposed to handing over your own money may sound like a less risky way to help someone. It may not be. Attaching your name to someone else’s loan comes with potential pitfalls.
Be aware that the loan will now appear on the credit reports for both the borrower and the co-signer. That may reduce the amount of money you might otherwise be able to borrow, and if there are late payments, it will affect the co-signer. In the worst case scenario, if the primary borrower defaults on the loan, you will be the one responsible for repaying the loan, and the negative information will appear on your credit report.
If you loan money and the loan is not repaid, you can usually deduct money not repaid as a bad debt. To deduct bad debt, you must have documented the loan with a promissory note or other similar documentation of the terms of repayment, or the loan will be indistinguishable from a gift.
Be aware of any taxes you may be assessed if you decide to loan money. You may need to file a gift tax return if you lend someone more than $14,000, which is the amount set by the IRS for 2013. Spouses can combine their annual exclusions to double the amount of the gift. Consult a CPA to determine how you will be affected by the loan. If your borrower defaults, be sure to document your attempts to collect the funds. You will need this information to write off the loan down the road.
If you don’t charge interest on the loan, the IRS may get curious. If the interest rate you do decide to charge is less than the most recent applicable federal interest rates, the loan can be considered a gift and trigger a taxable event. In addition, interest received by a lender of a loan is generally taxable. While the amount of interest payments on a personal loan may not be large, it is important to know that interest payments on unsecured personal loans are not tax deductible.
Trust Your Judgment
If you’re feeling uncomfortable with the process of lending to a friend or family member, it may be time to step back and reconsider. Maybe there are other ways you can help. Offering to buy groceries, donating a gift card, helping with a job hunt, or connecting someone with a personal financial planner may help someone restart their financial journey on a positive note.
If you have questions about your taxes or other personal financial planning topics, consult a CPA. To find a CPA in Pennsylvania, ask family and friends for recommendations or use PICPA's CPA Locator.