Borrowing from family can be cheap, but don’t ignore the IRS

Rubber band around rolled up money

Pssst. Hey, buddy, can you spare a dime?

You’re a generous person, so you have no problem lending a little money to a family member.

But remember, for large sums, there are some rules to follow to keep you in the good graces of the IRS.

If you plan to lend or borrow money for a car, a home down payment, business capital, debt consolidation or help getting through a period of unemployment, it’s wise to think through and document the terms of your agreement.

Doing so keeps things clear between the borrower and the lender -- very important in a situation where a misunderstanding could strain or break a relationship.

You’ll need to agree on the loan amount, the repayment time, the interest rate you’ll charge and what collateral or security you have.

Write down and sign your agreement, a crucial step for both family harmony and IRS compliance. Do it yourself in plain English or get standard loan documents through www.nolo.com.

The IRS doesn’t insist that you charge your child interest on loans of less than $10,000. A few other convoluted rules might let you avoid charging interest on loans between $10,000 and $100,000.

Your tax adviser can help you decide if these apply to your situation, or you can just charge the interest. Rates are so low right now that the interest payments might be cheaper than your accountant’s time.

Loans that don’t meet the conditions to be interest-free are subject to the IRS’s going interest rates for inter-family loans.

Called the Applicable Federal Rates, or AFRs, these rates vary with a loan’s duration and change monthly. Find the current month’s AFRs at the IRS website.

For October 2011, for instance, rates ranged between 0.16% and 2.95% -- much better than a borrower would do with a bank and also more than a lender would earn on a certificate of deposit, making a family loan a potential win for both parties.

Lenders declare interest as income and pay taxes accordingly. Borrowers may be able to deduct interest on their itemized tax returns. A tax adviser can tell you if your situation qualifies.

If you don’t charge interest and the IRS thinks you should have, the IRS may see the loan as a gift and levy gift tax accordingly.

Or the IRS could assume the lender charged interest but failed to report that interest as income, then charge both tax due and penalties.

It’s never a good idea to antagonize the taxman -- and with rates so low, there’s very little repayment for running an unnecessary risk.

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