Be careful when lending to relatives

THE BALTIMORE SUN

It's not unusual to want to help a family member out of a financial pinch with a loan, or to tap relatives for a cash advance when a bank won't touch you.

And it's not unusual for that IOU to change the relationship, and not necessarily for the better, experts say.

"Each may have expectations about how the other one is going to handle the debt," said Dr. Carol Watkins, a psychiatrist with Northern County Psychiatric Association in Lutherville. "The person who gets the money, in some cases, may have the feeling that because they got the money from a relative, this particular debt is a lower priority to pay back. That may not be the way the other person perceives it."

And if the relationship is strained to begin with, the misunderstanding can exacerbate tensions, she said. Watkins said she has seen cases in which "the person who got the money out of guilt starts avoiding the person who lent it to them."

Even with so many avenues for borrowing these days, from bank loans to home equity loans and credit cards, people often turn to their nearest and dearest when strapped for cash.

Borrowers know that Uncle Harry won't put them through a credit check or charge them interest. As for lenders, Mom and Dad might want to help a child buy a home, or they find it hard to say "no" to a loan when they are the only ones standing between Cousin Millie and foreclosure.

Half the time, family loans strain the relationship, said Barry Glassman, a financial planner with Cassaday & Co. in McLean, Va. "The other half, it works out. Or the lender forgave the loan."

Financial advisers have plenty of tales of family loans gone bad.

Robert Mewshaw, president of the Van Sant & Mewshaw in Lutherville, recalled a client who lent a child money to start a business and agreed to guarantee the child's bank loan.

The business went belly up two years later, and the parent wound up selling a house and investments to cover the bank loan, he said. Parent and child have been estranged ever since.

Before they embark on a loan, family members should take steps to protect the lender, the borrower and their relationship, experts advise:

Lenders should go in with eyes open. "If an institution won't lend the money, there's a reason," Glassman said. Understand that the borrower might have a poor credit history or too much debt, he said.

Get it in writing. Without terms written down, it's easy for both sides to forget or become confused about the deal. Include how much is borrowed; how much, if any, interest will be charged; when and how the loan will be repaid, and what will happen if the borrower defaults or the lender gets into financial difficulty and needs the money back immediately.

Lawyer Jeff Agnor, of Davis & Agnor in Columbia, suggests putting the terms in a promissory note, sort of a "first cousin to a check." The legal document will make it easier for the lender to collect what's owed if, say, the borrower dies or files for Bankruptcy Court protection, he said.

Putting it in writing also substantiates claims that the money is, indeed, a loan and not a gift, if the IOU comes under the questioning eyes of an IRS auditor, said Matt Wagner, an accountant and partner with Sturn Wagner Sacclaris & Lombard in Annapolis. If deemed a gift, the loan could end up triggering gift taxes or prevent the lender from taking a tax deduction if the borrower later defaults.

Don't forget Uncle Sam when lending to Uncle Joe. The Internal Revenue Service is not concerned about loans of $10,000 and under, because individuals are allowed to give away that amount each year to another person without gift taxes becoming a factor.

For larger loans, though, the IRS requires lenders to charge interest and expects that income to be reported on tax returns, whether it's collected or not, Wagner said. The Treasury Department each month sets the minimum rate to be charged. This month, the rates range from 6.09 percent to 6.33 percent, depending on the length of the loan.

In some large loan cases, the IRS might consider the uncollected interest as a gift rather than income, Wagner said. And if that interest exceeds $10,000 any year, the lender must file a gift tax return, he said.

What happens if the borrower defaults? Again, there are emotional and tax consequences.

"No one usually takes a close relative to court, although in certain families the guilt can be even worse," Glassman said. Most of the time the loan is forgiven but sometimes not forgotten by those stiffed, experts said.

Lenders face two tax options on loan defaults. They can deem the unpaid loan a gift or write it off as a nonbusiness debt, Wagner said. If it's a debt, the lender can deduct the loss, a limited amount each year, from taxes.

The bad news for borrowers, if they're not under Bankruptcy Court protection, is that the unpaid debt is considered income, and taxes must be paid on it, Wagner said.

Borrowers might be eligible for tax deductions, depending on what the money is used for, said Sam Serio, an IRS spokesman. For instance, if the loan is used to buy a home, the interest can be deducted if the loan is secured by the residence, he said.

The bottom line on family loans, experts said: Don't lend any money you can't afford to lose. "If it's going to disrupt your Thanksgiving dinner to loan money to your brother or child, don't do it," Wagner said.

Some loans have happy endings.

Psychiatrist Watkins said she borrowed several thousand dollars for medical school from her parents when interest rates were high. "As soon as I finished my residency, that's the first loan I paid back. I did that before I bought a house or made any major investments," she said.

She also paid it back with interest, though her parents didn't ask for any. And she wrote them a thank you note on how the money helped her through school.

"They showed it around to people," she said. "It made everyone feel really good."

Do you have a personal finance issue of general interest that you would like to see addressed in this column? Contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose@baltsun.com.

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