Should you Lend Money to Family Members?

*Authors note: this article should not be construed as legal advice, but raises issues that affect the legality of lending money.

Joan Brandmeyer loaned her son $10,000 toward the purchase of an RV. Two years later, the money is all paid back, with interest, and Joan enjoys several excursions each summer with her son and daughter-in-law. Ray Pembroke on the other hand, loaned his younger brother $10,000 to start a printing business. Seven months later the business folded. Five years have past and Ray has collected less than half of his money.

There's no doubt, lending money to relatives is a highly controversial issue. Those who have been burned can rant and rave for hours about their folly. But there are numerous others who have loaned money, been paid back in a timely manner and made a fair interest rate. Everyone agrees, though, deciding whether or not to loan to a family member is especially tough.

Any lending includes some amount of risk, yet at the same time all want to believe our loved ones are totally honest, above-board individuals. You should ask yourself: is this person responsible? Although it's difficult to be objective, be honest in your assessment. Do they have a good track record in their other financial dealings, or did they come to you because no one else was willing to loan them money? If this is the case, think long and hard before saying yes.

It's very important to consider the consequences if your relative defaults. How will you handle the situation? Could you, (or would you) bring legal action against your own son, daughter, sister or beloved Auntie Sue. Can you live without the money, should the worst happen?

If you choose to make such a loan, treat the entire arrangement as business-like as possible, by drawing up a formal note. Even if you trust your relative 100%, people do get divorced and die accidentally, so you need this documentation. It's safer for everyone involved. You can find sample legal forms at most banks, office supply stores or at your local public library. If the amount is large, consider hiring an attorney to draw up this paperwork. In addition, if your relative does default, you'll need an enforceable loan document to deduct the loss on your income tax.

Spell out the specific terms in detail. Be certain your loved one understands it's a "real" loan with all the expectations of a bank loan. Set a date each month for the payment, agree whether it's to be a joint or individual contract, decide on the length of the loan and the interest rate.

Although most people try to give their relatives a break on interest, you should still charge a reasonable amount. That way, you'll both benefit from the transaction. Also, each state limits the amount of interest that can be charged for a debt. Charging more than this limit is called usury and is a crime. If the interest rate you're considering is a great deal higher than current bank interest, check with a lawyer before proceeding.

If you are lending more than $10,000 or if the borrower has more than $1000 in investment income a year, the IRS sets a minimum for the amount of interest you must charge. This applicable federal rate (AFR) fluctuates monthly and is also dependent on the length of the loan. You can call the IRS at , to get the current rate and you'll need to tell them the terms of the loan. Like most IRS provisions this is subject to some exceptions.

When making a home loan, the lender must file a notice of a mortgage on the deed with the county recorder. In all respects, handle it exactly like a bank loan and the house itself can be your collateral.

Unfortunately, specifying property of the borrower as collateral for the loan is not as easy as it might seem. For example, in most states to legally establish property as collateral for a loan, a special agreement, called a "security agreement" must be signed by the borrower in addition to the primary loan contract. This security agreement must also be filed either with the Secretary of State or the local county recorder, depending on the classification of the collateral. This filing is required to put other potential lenders "on notice" when contemplating loans on the same collateral.

As you can tell, loans involving real estate and/or collateral can get more convoluted, it would be smart to obtain legal advice so that all your rights are protected.

If you're loaning money to your relative to start a business or for an existing business, it's best to make the loan directly to a particular person, rather than to a partnership or business.

Keep careful records of all payments made including the date of payment, along with the beginning and ending balance, in case there is any dispute in the future.

If all this seems like too much confusion, you might consider giving the money as a gift. However, even with a gift it is wiser and safer to document the transaction. Under current law, you can give up to $10,000 a year to an individual without worrying about any federal gift taxes.

A married couple may, by agreement, give up to $20,000 per year and still avoid federal gift taxes. This "gift-splitting" requires the couple to file appropriate forms with the IRS, along with their tax statements. This provision allows a married couple to give away more of their joint wealth and leave less at their death, which is subject to estate taxes.

Few things can create as much worry as money troubles, so don't cause yourself unnecessary anxiety. Lending money to family members can be smooth sailing with forethought and a solid measure of common sense.