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Money April 2014

Dollar Sense

Can You Lend Me a Few Bucks? I Promise… I’ll Pay You Back

By Teresa Ambord

That’s why you need to put the loan on paper and get all parties to sign it. If the borrowers complain you are acting like a bank, remind them they are treating you like an ATM.

Whether you are well off or barely making it month–to-month, there always seems to be someone lower on the food chain who wants to borrow your money. A family member, a friend, maybe even a coworker or acquaintance. Too often, they’ll promise you anything, accept any terms or conditions, until they get the money. Then, good luck getting repaid.

Don’t let yourself be pressured into lending money you can’t afford to do without for the duration of the loan. But if your money is languishing in the bank collecting almost no interest, you might do well to make a private loan to someone you feel confident can and will pay you back. Chances are the borrower will also get a better deal from you than he or she could from a bank. Just make the decision with a cool head, and whatever you do, don’t go into it lightly. If you decide to make the loan and you structure it properly, it could be a win/win situation.

Before you turn over a single dollar, follow some practical rules from financial experts:

    1. Put it in writing. Put it in writing. Put it in writing. If this makes you squirm, I recommend one thing. Don’t make the loan until you’ve watched a week’s worth of "Judge Judy." It’s the same story over and over and goes something like this: Mama scraped together $2,000 out of her Social Security so 34-year-old Junior could buy the jalopy of his dreams. He’d pay her back out of his tax refund, he said. But after he blew it on a Vegas weekend, there was nothing left. Junior’s defense… “She never said nothin’ about no loan. It was a gift. I can’t believe my mama hauled me into court!”

      That’s why you need to put the loan on paper and get all parties to sign it. If the borrowers complain you are acting like a bank, remind them they are treating you like an ATM.

      Other compelling reasons to formalize the deal:

      • If the loan is structured properly and you do not get repaid, you may be able to write the loan off as a non-business bad debt. You not only need to have the loan in writing, but you must also make a good faith attempt to collect, otherwise if you are audited, the IRS may disallow your deduction. Generally a bad loan can be treated as a short-term capital loss on your tax return. On the flip side, if the loan is not documented and you write it off and undergo an audit, the IRS may deem it to have been a gift and disallow your deduction. Depending on the amount, you could also be hit for not filing a gift tax return.
      • If there is real estate involved, you may also need to consult an attorney, and get the documents recorded.

    2. Don’t be afraid to charge interest. But how do you set the interest rate? If the loan is below $10,000 it’s usually acceptable to charge whatever interest rate you are comfortable with. If the loan is for $10,000 or more, you’ll need to follow IRS rules, so talk it over with your tax adviser to avoid penalties.

      Let’s say you are lending $9,000 to your brother-in-law for some minor home repairs. He’ll probably expect low or no interest. But of course it is your money and it could be earning some sort of return, so if you’re giving up the use of your own money you need a reward. Banks charge higher interest for higher risk borrowers. You should do the same. Take an honest assessment of how risky it is to lend this guy money. Higher risk equals higher interest. The longer the loan life, the greater the risk, and therefore the higher the interest should be. On the other hand if your brother-in-law is a stand-up guy and you have reason to believe you’ll get repaid fairly quickly, you could give him a low rate compared to a bank loan and still outdo the interest income a bank would pay you.

      Don’t beat yourself up over charging interest. It’s your money and even assuming you are fully repaid, you are giving up the use of it for a time. The more businesslike you keep this, the better you’ll fare if you do have to drag your brother-in-law before Judge Judy.

    3. Keep emotion out of it, family or no family. Don’t ever lend what you can’t afford to lend (and possibly lose) and don’t lend if you have no realistic expectation of getting paid back. Better to just call it a gift than to ruin a family relationship and end up a Rolaids junkie.

      Notice, when your loving niece comes, hat-in-hand, asking for a loan, she’s willing to make any deal, do anything, swear to be your most devoted fan forever. That gratitude may fade quickly after the money is spent and you want to be repaid. So before the ink is dry on the check you write, take advantage of the borrower’s pre-funding willingness, and get it in writing.

      A scrap of paper signed by both parties is better than nothing… but this is your money. Take a little extra time to do it right. Type it up, set an interest rate, schedule payments, and take your borrower to visit a notary public to get the agreement notarized. Notaries are easy to find and the process is quick and inexpensive.

      The last thing you want is to be yet another family raked over the coals by Judge Judy on national television. Don’t be that lender.

 

How to Charge Interest

If you do lend a substantial amount of money interest-free, you could end up with tax and gift consequences. Before you lay down the first dollar, talk to your financial adviser. A good adviser will likely tell you to forget “interest-free” and charge applicable federal rate (AFR). Each year, you’ll need to report the interest you receive on your tax return, and your borrower may be able to claim the interest expense (depending on how the proceeds of the loan were spent).

Your adviser can tell you what the current month AFRs are. If the loan is a “term loan,” meaning it has a specific end date like a five-year loan, you can use the same rate for the life of the loan. For example, here are the AFRs for March 2014:

  • 0.28 percent for "short-term" loans of three years or less.
  • 1.82 percent for "mid-term" loans of more than three years but no more than nine years.
  • 3.31 percent for "long-term" loans more than nine years.

So let’s say, in March 2014 you lend your daughter $60,000 for a business venture, and set up a 10-year monthly repayment plan. The AFR to use is 3.31 percent and this will apply until the loan is paid off.

On the other hand, suppose you set up a “demand loan,” meaning you can demand the money back at any time. For demand loans, the AFR does not last the life of the loan. It must fluctuate as the “short-term” rate listed above fluctuates.

You can check the current month AFR by going to http://apps.irs.gov/app/picklist/list/federalRates.html and clicking the appropriate month.

 

Teresa Ambord is a former accountant and Enrolled Agent with the IRS. Now she writes full time from her home, mostly for business, and about family when the inspiration strikes.

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