The family loan, done in writing

In short

A friend of mine once lent his brother money on a handshake, and the two of them did not speak at Thanksgiving for three years. If you are thinking about lending to family, put it in writing first. A written note names the amount, the interest rate, and the date each payment is due. The Internal Revenue Service sets a minimum interest rate each month for loans like this, called the applicable federal rate, and a loan below it can trigger tax questions. The lender may also owe tax on any interest received. Loans above a certain size bring gift tax paperwork into the picture. Keep a record of every payment. Paper is kind to families.

The whole of it

What it is

I once watched a man hand his nephew a check for $8,000 over a plate of pot roast, with no more said than "pay me when you can." Nobody meant any harm. But two years later, neither one could say what was owed, and the pot roast had gone cold in more ways than one.

A family loan is simply money lent between relatives, such as a parent and a child, or a brother and a sister. What makes it unconventional is that no bank stands in the middle. The lender takes the place of the bank. That can be a real kindness. It can also go sideways if the terms live only in two people's memories.

Doing it in writing means a promissory note. That is a short document in which the borrower promises to repay a set amount on set terms. It need not be fancy. It does need to be clear.

How it works

If you are thinking about lending to a relative, you have probably wondered whether to charge interest at all. Here is the plain answer. The IRS publishes the applicable federal rate, known as the AFR, every month. It is the lowest interest rate the IRS treats as fair on a private loan. If the loan carries less than that rate, the IRS may treat the forgone interest as a gift from the lender, and sometimes as income too. The rules on this sit in Section 7872 of the Internal Revenue Code, which governs below market loans.

The AFR comes in three tiers by loan length. Short term covers three years or less. Mid term runs over three years up to nine. Long term is anything past nine. The lender picks the tier that matches the note. The rate that applies is the one in effect for the month the loan is made, and for a fixed rate note it stays put.

There is a small mercy in the rules. Section 7872 of the Internal Revenue Code sets aside a small loan threshold for loans between individuals, and the figure is the current figure, which the official source publishes each year. The statute attaches conditions to that exception, so the lender should read the exact wording on the IRS site before counting on it.

Gift tax is the other wire. Lending is not giving. But if the lender forgives some of the loan, or later says "forget it," that forgiven part may count as a gift. Gifts above the yearly exclusion call for a gift tax return, Form 709. The exclusion is the current figure, which the official source publishes each year. Filing a return is not the same as owing tax. Most people owe nothing at filing time because the lifetime exemption, the current figure, which the official source publishes each year, absorbs it. Still, the form must be filed.

The numbers, and where to find yours

You have probably wondered where to look for the right rate. The IRS posts the applicable federal rates each month in a Revenue Ruling, and the agency's website lists them under its AFR pages. The ruling is the official source. A bank rate or a number from a blog is not.

Three figures matter for any family loan. The first is the AFR for your loan's length, which today is the current figure, which the official source publishes each year, the current figure, which the official source publishes each year, or the current figure, which the official source publishes each year. The second is the small loan threshold, the current figure, which the official source publishes each year. The third is the yearly gift exclusion mentioned above. Each one changes, so look up the current figure rather than trust a number from memory.

Your own numbers are simpler. They are the amount lent, the rate you set, the number of months, and the payment you agree on. Write all four into the note.

A worked example

Let me tell you about Ruth, a retired schoolteacher in Ohio. Her daughter Carla wanted to buy a used delivery van for her bakery. The van cost $24,000, and the bank wanted a rate that made Carla wince. Ruth had savings sitting in an account earning very little, so she offered to lend the money.

They agreed on a three year loan. That put it in the short term tier. For the example, suppose the AFR for that month was 4 percent, and Ruth set the rate right at 4 percent so there would be no gap.

The note named Ruth as lender and Carla as borrower. It listed the amount of $24,000, the rate of 4 percent, and 36 monthly payments. A standard payment formula gives a monthly payment of about $709. Check it with the round numbers. Thirty six payments of $709 add up to $25,524. Take away the $24,000 borrowed, and the interest comes to $1,524 over three years.

Here is how the first month works. Interest for one month is $24,000 times 4 percent divided by 12, which is $80. Of Carla's $709 payment, $80 is interest and $629 pays down the loan. The balance drops to $23,371. Each month the interest share shrinks a little, and the principal share grows.

Ruth reports the interest she receives as income on her tax return. Over the whole loan that is $1,524. Carla keeps a simple ledger of each payment and the date. Both of them sign the note, and each keeps a copy. Nothing fancy. A good pen and an honest hour at the kitchen table.

Now suppose Ruth had charged nothing. The forgone interest would be about $1,524 across the loan, and under the below market rules the IRS could treat that gap as a gift from Ruth to Carla and as interest income to Ruth. The note at 4 percent avoids the whole tangle.

Where it goes wrong

I have seen good families strain over loans that began with the best of hearts. Most of the trouble comes from a few places.

The first is the handshake. Without a note, there is no proof of the terms, and memory is a poor bookkeeper. Write it down.

The second is the quiet forgiveness. A parent says, "Never mind the rest." That is a generous thing to say. It is also a gift, and the gift tax rules may apply. Say it on paper, and look at Form 709.

The third is the missed payment. A borrower falls behind, the lender says nothing, and resentment grows like weeds. A note should say what happens when a payment is late, and both people should agree to it while they are still on good terms.

The fourth is the loan used to buy a home. If the lender wants the interest to count for the borrower's mortgage interest deduction, the loan must be secured by the home and recorded under state law. That takes more than a signed note, so a local attorney is worth the visit.

The fifth is the other children. A loan that is never repaid can look like an early inheritance to a brother or sister. A short, honest conversation now beats a long, sore one later.

Questions to answer before you leave this page

Have you written down the amount, the rate, the number of months, and the payment, so nobody has to guess later? Do you know which AFR tier fits the length of your loan, and have you looked up the current rate on the IRS site? Is the loan $10,000 or less, or does it sit above the small loan line? If the borrower cannot pay, what will the two of you do, and have you said so out loud? Will the lender report the interest as income, and will both sides keep a ledger of every payment? If you ever forgive part of the loan, will you put that in writing and check whether a gift tax return is due? And last, can you each sit at the same table next year and feel good about what you signed?