Not many people are as lucky as Donald Trump, who recently revealed that he got a $1 million loan from his father early in his career. But parents can still offer their adult children a leg up by lending smaller amounts.
This week, the Republican presidential candidate explained that he had used the “small loan” — which would now be worth many times the original amount due to inflation -- to start buying properties in Manhattan. Trump also said that he had to pay his father back with interest.
Charging interest is among the many tips experts give parents considering similar arrangements, but for amounts with fewer zeroes. A handshake and a check aren’t enough to keep family relations intact – and stay on the right side of the IRS.
“It can be a great way for parents who are earning low interest to increase their return and for kids to get a lower interest-rate loan,” says Mitchell Kraus, owner of Capital Intelligence Associates, a wealth management firm in Los Angeles. “But it needs to be well thought out.”
Get it in writing
Financial planners largely agree that the best way to avoid fractured relationships down the road is to put the details of the loan in ink.
“What I find with these loans, because they’re friends or family, they don’t spell out the terms of the loan and problems come up later,” says Tim Watters, principal of Watters Financial Services in Paramus, New Jersey.
The loan document should include basic information like the borrowed amount, the interest rate, the length of the loan and terms of repayment. Include minute details like when each payment is due, the amount of each payment and if the payment includes both principal and interest.
The document should also explain what will happen if the loan is not paid back. If the loan was for real estate, do the parents foreclose on the child’s house? Is the outstanding amount deducted from the child’s inheritance if the parent dies? These scenarios must be ironed out to prevent misunderstanding and conflict, Watters says.
This needs to be a formal document with a promissory note or deed of trust for real estate-secured loans, says Elizabeth Grahsl, a vice president at Prosperity Bank. Loan forms can be drawn up by a lawyer or downloaded online.
“Proper documentation enables the borrower to deduct loan interest if funds are used for business or real estate purposes,” Grahsl wrote in an email. “And it can also can enable the lender to deduct losses if the loan is not repaid.”
Don’t mess with the IRS
Parents lending the money are required to report any interest income from the loan to the IRS. Almost two-thirds of Americans aged 45 and over aren’t familiar with that obligation, according to a 2012 survey from National Family Mortgage.
The consequences of not reporting the loan income are the same as any other form of tax evasion: steep penalties, interest and possible prosecution, Grahsl says.
Additionally, the interest rate on these loans must comply with IRS rules to be considered a taxable event. The IRS every month publishes the Applicable Federal Rate (AFR), which is the minimum rate that loans must carry, says Thomas Scanlon, a certified financial planner in Manchester, Connecticut.
“The rate depends on the loan duration and the payment cycle,” Scanlon says. “Right now, these rates are very modest. Family members can certainly charge more if they want.”
If the loan rate falls below the AFR, then the IRS would consider the loan a gift, which could trigger tax penalties if the amount is large enough.
Recognize the pitfalls
Despite even the best preparation, loans between family members and friends can go wrong. First, parents should never lend money that they can't afford to lose.
“Essentially we tell our clients that many family loans turn into grants. If the parent can financially handle this loss, no issue,” he says. “If, however, they are counting on being paid back and they aren’t, that’s not good.”
Parents need to honestly assess the riskiness of the borrower and not be clouded by love. For instance, if a child needs the money to get out of credit card debt, ask why he owes so much in the first place. Debt from unrestrained spending is a red flag, whereas debt from a medical emergency or temporary job loss probably is not, Watters says.
As lenders, parents should avoid attaching “non-financial strings” to the loan such as dictating family trips or grandchildren’s schooling, Grahsl says.
The biggest drawback for these loans can be the emotional toll, experts say. For example, a spouse may feel uncomfortable being in debt to in-laws. Siblings may wonder why they didn’t get the same deal. Unpaid loans could cause resentment for parents, especially if their children are spending frivolously, while forced payments could breed similar feelings among children.
“Loans should not take place where the family isn’t already close or there are other relationship issues,” Kraus recommends. “The loan can aggravate these already tender issues.”