How To Arrange A Loan Between Family Members

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Parents can help their children with a down payment without running afoul of the IRS.

Back when they were feeling flush, many parents helped their children with down payments on their first homes. Now some are reluctant to give, worried that they won’t have enough left for their own retirements or that their children may become too dependent on handouts.

Fortunately, there’s an alternative to not helping at all: Lend them the cash. If you want to help your children (or convince your parents to help you with a down payment), then there are several ways to do so without triggering nasty tax penalties. Los Angeles CPA Michael Eisenberg recently helped a father structure a $2,000-a-month loan to his out-of-work son. The expectation is that the economy will turn around and the son will get a new job; the documents require him to start paying the loan back in 2011. “Make sure everyone is clear on the terms–is it a loan or a gift?” Eisenberg says. “You’ve got to be clear which way you’re going, or it can ruin the family relationship,” he adds.

An ambiguous loan can also ruin your relationship with the Internal Revenue Service, which might argue the loan is really a gift, possibly subject to gift tax. The key to avoiding either family or tax trouble is to put things in writing and, in most cases, to charge your kids a minimum IRS-set rate of interest. The interest they pay is taxable income to you.

There are exceptions: If you’ve lent a child less than $10,000 in total, you don’t have to charge interest. Plus, there are some convoluted rules that might allow you to avoid charging interest on loans between $10,000 and $100,000. But those rules don’t seem worth fooling with now, given how little interest you have to charge.

For November, the IRS minimum interest rates range from 0.7% a year for loans of three years or less to 4% for loans longer than nine years. On a loan of $20,000, those interest rates fall between $140 to $800 a year.

Setting this up needn’t be expensive. You can buy standard loan forms through Nolo.com. Or one of billionaire Sir Richard Branson’s latest ventures–Virgin Money–will generate the paperwork for $99. But if you’re lending a substantial amount, or for a long period, you should consult with your lawyer or accountant about the gift and estate tax angles and how any outstanding loan will be treated should you die.

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