How to Lend Money to Family and Friends

Keeping the IRS Off Your Back

If you do choose to lend the money, your next step is to draw up an enforceable note. It may sound cold, but without adequate proof, the IRS may interpret the loan as a gift, which has all sorts of potentially negative repercussions.

The note should contain a fixed loan amount, a stated rate of interest, a specific period of repayment and security or collateral.

The minimum rate of interest you must charge is determined by the IRS. If you charge no interest or below the IRS-dictated levels, the IRS will tax you as if you had received their prescribed amount anyway.

C'mon … an official promissory note to be signed by a family member?

We're not talking about not loving your family. We are talking about protecting the money for which you have worked so hard, and protecting the trust and affection you share with the borrower. No matter how much you trust your family member, what happens to your money if there is a divorce, loss of employment, a bankruptcy, a serious disability or (God, forbid) a death?

Another important reason for proper documentation is the fact that if your loan is not repaid, you may be able to take a "bad debt" tax deduction.

When lending money to start or expand a family member's business, the proper paperwork becomes even more important because, in the case of unpaid debt, you may be able to take a dollar-for-dollar deduction as a short-term capital loss on Schedule D, form 1040.

Again, if the IRS calls it a gift because of no/inadequate documentation, you may lose that important deduction … not to mention losing your money!

The final decision "to lend or not to lend" is, of course, as much a question of emotions as it is one of money. Just be aware of the many ramifications of this seemingly simple transaction. Don't let your heart overrule common sense – and get you all into trouble.

If you do decide to proceed with lending money, click here to use our sample loan note to protect everyone involved.