I was recently sitting down with a couple with significant income and assets. Their liabilities included a loan from their parents so that they could make a significant down payment on their home several years prior. When I asked about the loan interest and repayment strategy, they said the agreement was to repay the money to their parents when they could and they didn’t agree to pay any interest.
If I were in the position of the parents, this would concern me. Not only does the couple already have the ability to pay off the loan, but it appears that they don’t have the respect for the parents to honor the terms initially set forth. Furthermore, by not treating the loan as a loan, they are setting their parents up to be strapped with a significant tax bill.
These are some of the financial and emotional considerations of lending money to friends and family, and how to avoid ending up in a compromising financial position.
Emotional Considerations
No matter how much money you’re considering lending to a loved one, there may be some difficult emotions that accompany that. Lending money to a loved one can potentially change your relationship to the person you’re lending to in several ways:
- It can lead to an imbalance of power.
- It can lead to awkwardness or distancing of the relationship.
- It can contribute to a lack of trust.
- It can cause emotional damage worse than the impact of losing money altogether.
- It can permanently alter the way you and your loved one see each other.
Financial Considerations
Unless you have considerable wealth and can meet all your financial goals without the money you lent, you are likely depending on the repayment of the loan for your own financial security. For this reason, you must critically assess whether this person can pay the loan back to you. If they have poor credit and all banks are denying them, think twice about putting yourself in that risky position. Additionally, if you gave out a large loan and the borrower is not consistently paying back either the principal or the interest, the IRS might consider this a gift and tax you accordingly.
Let’s say you loaned $100,000 to a loved one for a down payment but you didn’t sign a loan agreement, charge interest, or take the borrower to court to collect the debt when it wasn’t paid back. In this case, you’re not only out $100,000 but you would also be assessed on a gift tax obligation of 40% of the amount over the gift tax exclusion. If this happened in 2024, the tax consequences would be an additional $32,800.
You should also be wary of interest-free or low-interest loans because the foregone interest may end up being considered a gift. This is known as a gift loan.
Another consideration is the opportunity cost of not being able to use the money to generate interest or investment gains on your own. If you have a long time horizon and significant tolerance for risk, this opportunity cost could be immense. If instead of lending money out, you had invested $100,000 over five years and had compounding returns of 10% per year, your end value would be $161,051.
Explore All Options
If you’re not sure you want to lend out the money for some reason, there are other avenues you can take to still support your loved one.
Outright Gifts
If you discover that you don’t want the hassle of a loan and you don’t need the assets to hit your personal financial goals, you may just want to give your loved one a gift. In 2024, cash gifts up to $18,000 per person are free and clear of gift taxation. So, if you have a spouse and together, you want to give a couple money towards a down payment, you can gift up to $72,000 if structured correctly. Make sure to work with your tax planner to ensure this is done right if you’re hoping to make a significant gift.
I’ve even seen potential lenders opt to gift their loved one the interest a bank would charge them instead of offering an interest-free loan. This takes financial burden off the borrower and shifts the principal risk from you to the bank.
Co-Signing A Loan
If you trust your loved one to pay the money back but don’t want to shell out money or deal with creating an agreement yourself, you could offer to co-sign a loan to increase the borrower’s chances of gaining a loan through the bank. This does come with risks to you. If the borrower is unable to pay the loan back, the burden would fall to you.
Formalize The Agreement
If you do end up lending money, it’s essential to formalize the agreement. The terms, repayment schedule, and interest rate should all be decided and put in writing prior to any money changing hands.
If you want to make sure you’re following all laws and mitigating tax consequences, it’s critical to work with both an attorney and a tax professional. Working with a qualified financial planner can also support in showing what you can afford to lend out, how your financial goals are impacted, and assessing the borrower’s ability to repay the loan.
If something happens down the road, such as death or incapacity for either party, the written agreement will also serve to ensure all other parties are treated fairly.
Conclusion
Lending money to loved ones is a complicated matter that can result in unforeseen consequences. Consider your other options carefully and take steps to protect both yourself and your relationship with your loved one.
This informational and educational article does not offer or constitute, and should not be relied upon as, tax or financial advice. Your unique needs, goals and circumstances require the individualized attention of your own tax and financial professionals whose advice and services will prevail over any information provided in this article. Equitable Advisors, LLC and its associates and affiliates do not provide tax or legal advice or services. Equitable Advisors, LLC (Equitable Financial Advisors in MI and TN) and its affiliates do not endorse, approve or make any representations as to the accuracy, completeness or appropriateness of any part of any content linked to from this article.
Cicely Jones (CA Insurance Lic. #: 0K81625) offers securities through Equitable Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC (Equitable Financial Advisors in MI & TN) and offers annuity and insurance products through Equitable Network, LLC, which conducts business in California as Equitable Network Insurance Agency of California, LLC). Financial Professionals may transact business and/or respond to inquiries only in state(s) in which they are properly qualified. Any compensation that Ms. Jones may receive for the publication of this article is earned separate from, and entirely outside of her capacities with, Equitable Advisors, LLC and Equitable Network, LLC (Equitable Network Insurance Agency of California, LLC). AGE-7061825.1(09/24)(exp.09/28)