Lend a Hand or Give a Gift? - Part One

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If you’ve ever let a family member borrow money, you know it can sometimes become awkward and change your relationship.  Sometimes family members don’t feel comfortable charging interest to another family member.  Or, maybe someone feels uncomfortable being charged interest.  They perceive it to be a gift, when in reality it’s not.  It can be a slippery slope, so it’s important that everyone be clear on which kind of transaction it is and what the expectations should be.

Gifts can be a blessing to both giver and receiver. In 2014, the government allows each person to give up to $14,000 a year to as many individuals as they like, exempt from gift taxes.  For married couples, you can double this amount. This allows you to pass assets to children or other relatives without taxes – these can include securities that have potential to grow in value.

Lending, on the other hand, is an investment.  But, it can also be extremely beneficial to both parties. Suppose you earn 4% on your savings, and Johnny is paying 19% interest on a credit card balance he cannot afford to pay off.  If you loaned enough money to Johnny to repay the debt, and charge him 9% interest, you would get an extra 5% on your savings and Johnny would save 10% on the debt. You win, and Johnny wins!  However, if you do decide to help Johnny out, there are a few important things you should be aware of.

Put it in Writing

Even family loans should have a simple written agreement because it is rare that collateral is provided. The only security for the loan is the good will of the borrower. 

A written record will not only provided accountability, but it will also provide proof to others of the deal.  Even if the transaction is a gift, it’s important to keep a record to clarify it as such.  This can be especially important in settling an estate where siblings may not be aware of the transaction.   Having it in writing can save a lot of arguments down the road.  Sometimes borrowers even forget that they borrowed money at all, so having a written agreement protects everyone. And if it is a loan to be paid off, the agreement should be marked PAID and returned to the borrower when that day arrives.

But be aware, even with written agreements, approximately 14% of family loans end up not being paid.  So when deciding whether you can afford to make a loan, take into account that some or all of it might never come back to you.

Relationship May Change

You should also know this loan might change your relationship with the borrower.  Sometimes the lender might feel like they have some say in the financial matters of the borrower, and this can naturally lead to arguments and resentments.  The recipient may also feel weak or dependent, perhaps even guilty.  Treating the transaction as a business matter, with terms spelled out, can lessen this emotional danger.  Here are some important items to address in making this transaction.

Is a Lawyer Needed?

My favorite answer...it depends!  Usually not, though.  If it’s for a simple one-time gift or loan, just put the terms in writing and have both parties sign it.  A simple form for a loan, traditionally called a “promissory note,” can be used to document the transaction.  There are free templates that you can find by doing a search on the Internet.

Of course, having a lawyer involved is preferred and recommended if there are any complexities involved.  For example, if you are co-buying a home, collateral is being provided for a loan, you are making a gift under the Uniform Gifts to Minors Act, setting up trust, or some other complex transaction.  When complexity may be an issue, professional advice is a must.

What about earned interest?

Federal income taxes are due if you collect interest on a loan.  If you are ever audited and they discover you haven't been reporting interest earned, you are theoretically liable for tax fraud – same as Al Capone!  And, if you charge a generically low rate of interest, the government may consider that you actually earned a higher rate – defined by the IRS – even though you never received the money, and you will have to pay back taxes on those amounts.

These rules apply to family loans at certain levels only.  Therefore, you should consult with a tax professional on the loan terms if the loan is above $10,000.  Also, the interest may or may not be tax-deductible, depending on what it’s used for. 

Gift Giving

In the next installment of this two part series, I will discuss some of the rules you should be aware of when giving a gift.

Cris Cabanillas is a partner at Monterey Private Wealth located in Monterey, CA. He is an Accredited Investment Fiduciary and CERTIFIED FINANCIAL PLANNER practitioner.  As fee-only investment advisors, Monterey Private Wealth serves the communities of Monterey, Carmel, Big Sur, Salinas, Santa, Cruz, Gilroy, San Jose, and surrounding areas.