Draft a Legal Document for Loans Between Family Members

Like most people, you’d do just about anything for a family member. But what if a family member wanted to borrow money? Should you do it?

No — unless you are prepared to sue that family member.

Lending money to a family member is one of the quickest and surest ways to damage your relationship with that person. If the person can’t or won’t repay the loan, you’ll begin to resent him. If the person is a member of your side of the family, your spouse may begin to resent you. If you start to pressure the person for the money, he will avoid you. Other family members can become unwittingly caught in the middle, and before you know it, family gatherings become rife with tension.

And if the emotional implications aren’t enough, consider this: The only reason the person is asking you for money is because he couldn’t obtain a loan from a traditional source, such as a bank or credit card company. If these organizations don’t consider him worthy of getting a loan, why should you?

Get it in Writing

If you are still not deterred, then at least make sure you loan the money the proper way. This means you must handle the transaction as you would with any stranger. You must draft a loan agreement that will be signed by both parties. If the borrower is offended, or claims that your desire to put it in writing demonstrates that you don’t trust him, do not loan him the money. Any honest and reasonable borrower would be happy to sign a loan agreement. If they plan to pay you back, they will be happy to say so in writing. By the same token, anyone who is insulted over a request to commit to the transaction in writing never intends to pay you back at all.

In the agreement, state:

1. The amount of money that is being loaned. State this in numbers and letters, to avoid claims of miscommunication. Don’t just write $5,000. Print "five thousand dollars and no cents" on the document as well.

2. The date the money is to be loaned and returned. Be specific. "Sometime next year" or "after college grad-uation" doesn’t work. What if he never graduates?

3. The interest rate you are charging for the loan. Yes, you must charge interest on the loan. Family members are allowed to charge rates below current market rates, but the IRS requires you to charge some rate of interest — and it must be reasonable. If you loan the money at no interest, the agency will consider the loan to be a gift — making you (the lender) liable for gift taxes.

This gets even trickier if you loan a family member money to buy a house. Take John, for instance. He loaned his son, Tim, money to buy a house, but he failed to charge interest. The IRS made John pay income taxes on the interest he didn’t get from Tim (but which he should have gotten), and because he should have paid interest, Tim was granted a tax deduction on the mortgage interest he never actually paid! To the IRS, it didn’t matter that Tim borrowed the money interest-free; he should have been paying interest, so he got the break anyway. Go figure.

4. The payment schedule that the borrower must follow. State whether you will require periodic payments or a balloon payment, or some combination. Some examples:

Monthly payment of principal and interest. This is called an amortized loan, and works like your auto loan or home mortgage. In the early months, most of the payment is interest, with the bulk of the principal being repaid in the final months. Defaulting during the term of the loan means the borrower still owes most of the money he borrowed.

No monthly payments. The full loan and all interest are to be repaid at the maturity date. This is good when borrowers have little money or income now, but it’s a higher risk for the lender, since it requires the borrower to come up with a substantial amount of money at a later time.

Monthly payments of interest only. Known as a "balloon" loan, this is a hybrid of the above two. The monthly payments are smaller than the first example, but the final payment is smaller than the second example.

Or some other combination of the above. Just make sure it’s clearly spelled out in the document.

5. Penalties for not meeting the above terms. You must state what the penalties are for missed payments and bounced checks. State the grace period, and then make sure you assess the penalty. Failure to abide by the rules of the agreement could cause the IRS to conclude that it is not a true loan agreement.

If the borrower doesn’t pay you back, you are entitled to take a tax deduction as a "bad debt" on your tax return. But in order to win this deduction, the IRS wants to know that you’ve tried everything to get the money back — which may include taking the borrower to court. Are you prepared to sue a family member? If not, then you are not likely to be able to take this deduction.

Clearly, lending money to family members can be treacherous. If you are willing to do it when approached by a family member, the first thing to say is, "If we are to proceed, this must be handled as an arms-length transaction, as though I were a bank and you were the customer. I’m going to charge you interest and demand timely repayment — and everything will be in writing. Are you willing to accept these terms?"

If the borrower is not, then let him go elsewhere for the loan.