How to lend money to a relative without getting whacked by the I

You want to loan money to a cash-strapped family member? That's a nice sentiment, but please take my advice and make the loan the tax-smart way.

Here’s how to do that:

Charge IRS-approved interest rate

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If you make a loan to a family member and charge zero interest, you may face unfavorable and complicated tax rules, as I'll explain later. But you can avoid all the tax complications if you instead charge an interest rate that at least equals the IRS-approved applicable federal rate (AFR). Because AFRs are almost unbelievably low right now, you can be nice to yourself by charging the AFR while still being plenty nice to the borrowing family member as well.

Here's what I mean. The current AFRs for term loans, which means loans with a defined repayment schedule or a specific balloon payment due date, are as follows (based on loans made this month that charge interest based on annual compounding).

* 0.43% for “short-term” loans of up to three years.

* 1.53% for “mid-term” loans over three years but not over nine years.

* 2.30% for “long-term” loans over nine years.

Wow, those are some pretty low rates! However, AFRs are updated monthly in response to bond market conditions. Today’s super-low AFRs reflect the current super-low interest rate environment, which may not last much longer. AFRs for each month are published in Internal Revenue Bulletins and can be found at the IRS website www.irs.gov. With a term loan, the AFR on the month you make the loan applies for the entire loan term.

Tax-smart family loan strategy in action

Say you want to lend $50,000 to your adult daughter so she can buy her first home. You could make a nine-year term loan with a balloon repayment at the end and charge the mid-term AFR, which is currently only 1.53%. Your daughter can pay that same super-low rate for the entire nine years.

And if you want to make a 20-year loan instead? No problem. Just charge interest equal to the long-term AFR, which is currently only 2.30%. The kid can pay that same super-low rate for the entire 20 years.

On your side of the deal, you must include the interest income on your tax return (no surprise). On your daughter’s side of the deal, she can deduct the interest as home mortgage interest as long as you secure the loan with her home (a relatively simple legal procedure). Otherwise, your daughter generally cannot deduct the interest.

Here’s the important thing to avoid: if you make a demand loan (one where you can demand repayment at any time) as opposed to a term loan, the AFR is not fixed in the month you make the loan. Instead, you must charge a floating AFR based on ever-changing short-term AFRs. So if you believe as I do that interest rates will eventually go higher (maybe much higher), you’ll want to make a term loan if the objective is to offer a great interest rate to the borrowing family member.

Why interest-free loans are not a good idea

If you insist on making a totally interest-free loan to a family member, the dreaded below-market interest rules may apply. If they do, you must follow complicated rules to calculate imaginary interest payments from the borrower to you. Then you get to pay real, live income taxes on the imaginary interest. The imaginary interest payments can also trigger imaginary gifts from you to the borrower, which may eat into your valuable federal gift and estate tax exemption. Crazy? Yes. But I didn’t make these rules. Your beloved Congress did.

For loans under $100,000, there are some exceptions to the below-market loan rules. But the preferable approach is to avoid all the tax issues by simply charging an interest rate that at least equals the AFR. In any case, I think charging at least some interest on family loans is always a good idea, just to keep the arrangement on a business-like footing. Believe me when I say that keeping things business-like can save everyone a lot of unnecessary grief.

Mind the details

Last but not least, please put the loan in writing to make sure the IRS (and the borrower) will respect the deal as a loan rather than a gift.

This is easy to accomplish because several online services offer do-it-yourself loan documents for just a few bucks. I also advise collecting loan interest payments at least semi-annually and principal payments promptly when due. That shows you’re serious about getting your money back — with interest (albeit at a very favorable rate).

Follow these simple precautions, and you can give your family-member borrower some great loan terms while also keeping the IRS off your back.