If your family is like many, it's just a matter of time before somebody near and dear to you hits you up for a loan. This doesn't necessarily have to be a bad deal. You can help a family member with the capital to start a business, make an investment, pay personal expenses, or even buy a home. And the interest stays in the family, rather than going to some cold, impersonal bank or finance company. So, if done correctly, it can very well be a "win-win" situation.

However, if you decide to make the loan, there are some issues that you should understand relative to family loans and taxes. As with any loan, a loan to a family member should be made in a businesslike manner. You should make sure that you create an enforceable note that shows:

• The loan amount.
  
• A definite payment date or dates.
  
• A stated rate of interest.
  
• Collateral or security.
  

Without a valid note, the IRS could make a claim that there was really no loan at all, that the money was nothing more than a gift. If you are making the loan, this is the last thing that you want the IRS to do to you. And that is especially true if the loan goes bad some time in the future.

Interest issues
As the lender, you are required to report the interest you receive on the note as income. Simple as that. You'll report your interest income on Schedule B.

But the borrower's rules are not so clear-cut. How the money is used will determine whether the interest paid is deductible or not.

For example:
• If the loan goes toward paying personal debts and obligations, the interest paid on the loan will be nothing more than nondeductible personal interest.
  
  
• If the money is used for business purposes, the interest paid will likely be a business expense, deductible on the appropriate business schedule.
  
  
• If the proceeds are used to purchase investments, then the interest would likely be considered investment interest, subject to the investment interest rules.
  
  
• If the loan is used to purchase or refinance a primary or second residence, it is quite possible that the interest would be considered deductible home mortgage interest (assuming that the property is secured by the note in the form of a mortgage or trust deed).

So the interest rules can get quite complex for the borrower. If you are the borrower, make sure you know how the rules will work for (or against) you.

Interest on loans between related parties
As a lender, it is usually best to charge the family member interest at the going rate. Why? Because the IRS could view an interest-free loan as nothing more than a gift. Not only that, but the IRS might deem that you actually did receive the going rate of interest and gave that interest back to the family member. So, even if you don't charge or collect interest on the family loan, the IRS can step in and make you report interest income that you never received. It is best for all concerned to simply charge interest on the note at a reasonable and normal rate.

But in many cases, related individuals make loans for less than the normal going rate. That's not unusual at all. The IRS understands that fact of life, which is why it has established minimum loan rates for loans between related parties. These rates (known as the Applicable Federal Rates or AFR in tax speak) change on a monthly basis and are basically tied to the yield on Treasury securities. The AFR is determined by the length of the loan being made as follows:

• Short-term (three years or less).
  
• Mid-term (more than three years but not more than nine years).
  
• Long-term (more than nine years).
  

The IRS publishes applicable federal rates each month in the Internal Revenue Bulletin that you can find at the IRS website. Or, for another option, you can find the current AFR by pointing your Web browser to http://evans-legal.com/dan/afr.html.

Awwwww ... come on, Mom!
You explain to your child why you need to charge interest, and that is exactly what you hear in a loud and pitiful high-pitched voice. What's a mother to do? If you decide not to charge interest of at least the applicable AFR on the loan, you may run afoul of the below-market loan rules. You likely don't want to do that. But fear not! As usual, there are exceptions to the below-market loan rules.

The first exception is known as the $10,000 exception. The rules for below-market loans do not apply to loans of $10,000 or less, and to loans for which the proceeds are not directly used to buy income-producing assets (such as stocks or bonds). So, that clears the way for you make a loan to a family member for $10,000 or less and not charge interest ... as long as the proceeds are not used to purchase stocks, bonds, notes, or other income-producing property.

The second exception is (as usual) a bit more complicated. It's known as the $100,000 exception. That exception simply states that the loan must be for $100,000 or less and the borrower's net investment income (loosely defined as interest, dividends, and short-term capital gains, less any investment expense) cannot exceed $1,000. If the borrower's net investment income exceeds $1,000, the lender will be required to report interest income in an amount equal to the net investment income of the borrower.

Example: Marilyn makes a loan to her daughter Jill so she can start a business. Let's assume that, using the AFR, the annual interest would amount to $3,500. But Marilyn decides to simply forgo this yearly interest to help Jill with her tight money problems. So far, so good. There are no gift tax implications to Marilyn because the foregone interest is less than the $11,000 annual gift tax exclusion. As long as Jill has net investment income of $1,000 or less, Marilyn will not have any interest income to report. Likewise, since the interest isn't paid, Jill has no interest expense to deduct.

But let's change the picture a little bit. Let's say that Jill's net investment income amounts to $2,000. In this case, because Jill's net investment income is greater than $1,000, Marilyn will be required to report $2,000 as interest income, and Jill will have an interest deduction for $2,000.

The below-market rules can get a little tricky, so if you are thinking about making a loan with family members or any other related party (such as employee-employer, an individual to his or her corporation or partnership, and many others), make sure that you have a firm grip on the rules. You can read much more about related-party transactions and the below-market interest rules in IRS Publication 550 at the IRS website.

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