Borrowing from Family and Friends

If you need money, turning first to those you know is a common practice. You don’t have to fill out forms or pass credit tests to obtain the funds you need if your family and friends can afford to help you. From a tax perspective, here’s what you need to know.

1. Formalize your loan agreement

Just because you don’t have to complete paperwork doesn’t mean you should forgo formalities. Be sure to sign a promissory note for the amount you borrow. Having such a note protects the lender in case you default. The lender will then be able to take a nonbusiness bad debt deduction, assuming the loan is worthless and you have no possibility of repaying it. Without such a note, the IRS may argue that the funds were a gift to you, preventing the lender from writing off his/her loss.

Include in the note:

• Repayment period. Set up a schedule for repayment (e.g., monthly, quarterly) and for how many years
• Interest. Specify the amount of interest, if any, that you owe on the loan. See the consequences of not charging interest, below.
• Default. Spell out what happens if you default (e.g., what recourse the lender has).

There are numerous templates available online to help you create a promissory note. If the loan is substantial, it may make sense to have an attorney draft a note or at least have him/her review yours.

2. Below market loans

The tax law requires a lender to charge interest at least equal to the applicable federal rate (AFR) set by the IRS. If interest is less than this rate or there is no interest, the loan is a below market loan. As such, the lender has phantom income equal to the interest that should have been charged. You are treated as having paid phantom or imputed interest equal to this amount. Just to give you an idea of the AFR, if there’s a demand loan outstanding for all of 2016, the AFR is 0.78%.

However, there are two important exceptions to the below market loan rule:

• $10,000 gift loan. Loans to an individual up to $10,000 are exempt as long as the funds are not used to buy income-producing property (e.g., securities).
• $100,000 gift loan. No interest is imputed if the borrower’s net investment income is $1,000 or less. But even if it’s more, the imputed interest cannot be more than the borrower’s net investment income.

3. Deduction for interest

Whether you can deduct the interest (including imputed interest) depends on what you use the money for:

• If it is for personal purposes (e.g., a vacation), the interest is not deductible.
• If you use it to buy a home, the interest is deductible only if the loan is secured by the residence (and then the dollar limits for home mortgage interest apply).
• If you use the money for investment purposes, the interest is deductible as an itemized deduction to the extent of net investment income.
• If it’s to start a sole proprietorship, the interest is fully deductible. However, if the funds are used to start a partnership, limited liability company, or a C or S corporation, limits may apply.

Conclusion

Before you borrow money from family or friends, be sure that the lender(s) can afford to make the loan. This means that if you can’t repay it, the default won’t impact the lender’s standard of living. Remember, you likely will continue to see family or friends on holidays and other gatherings so you want to keep things cordial.