Any time you're thinking about lending some money to a member of your family, remember your Uncle Sam.
No, he's not interested in putting up the money. The truth is, he's already heavily in debt himself.But the government's tax authorities have a keen interest in any borrowing deals between private individuals, even those between parents and children, sisters and brothers and other close kin.
So before you go ahead and transfer the money, financial advisers suggest you give the deal some careful planning and set it up in a businesslike way. Otherwise, they say, you could run into problems that might put a heavy strain on your own finances, not to mention your relationship.
"Before you pull out your checkbook, be aware of the pitfalls involved when loaning money to family," says the accounting firm of KPMG Peat Marwick in the current issue of its planning newsletter Financial Independence.
"Structure a family loan just like any other standard loan to avoid scrutiny by the Internal Revenue Service.
"If you loan more than $10,000 to a family member, you could be required by the IRS to show proof that the money was indeed a loan. Otherwise, the loan could be considered a gift and subject to tax.
"A written, enforceable note is the best format. The loan document should list the amount you are lending, the interest rate you are charging, the date payment is due and a description of the collateral, if any."
Commonly, people who make loans to family members are willing, if not eager, to set a low interest rate or charge no interest at all.
But except in some special circumstances, the IRS does not look kindly on below-market or no-interest loans, especially if they take a form that looks like an attempt to dodge taxes.
If some doting grandparents wanted to make a large gift to a grandchild without incurring any gift taxes, for instance, they might "lend" the money to the grandchild at no interest, and then let the grandchild "default" on the loan.
"The IRS expects the loan to be repaid," says KPMG Peat Marwick. "If it isn't, the money will be considered a gift."
When you make a loan to a family member, you can certainly save the borrower money by reducing or eliminating the fees a bank or other financial institution might charge, and setting an interest rate your relative might not be able to get from any institutional lender.
But the rate must be at least as high as the so-called applicable federal rate set and published monthly by the IRS, based on prevailing market interest rates. Otherwise you will face the question of "imputed interest."
Under this principle, the tax authorities consider interest at least equal to the applicable federal rate to have been incurred by the borrower and received by the lender, whether it was actually paid or not.
Notes the J.K. Lasser Institute in the 1995 edition of its Your Income Tax guide: "As a lender, you are taxable on the `forgone interest,' that is, the interest that you would have received had you charged interest at the applicable federal rate over any interest actually charged."