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Dos and don'ts in lending to family members

With banks being so tightfisted these days, you might find more friends or relatives falling on hard times and turning to you for a loan. Or it might be you in need of that hard-to-get loan.

Should you do it?

Such a loan could prevent a loved one's foreclosure, bankruptcy or other dire fate.

Then again, the borrower might never repay and the relationship could blow up.

Matt Mittleman of Owings Mills, Md., says he lent money on four occasions to friends, figuring he would help his pals while earning a little interest. But when he tried to collect on his friends' verbal promises to repay, "It's almost like I'm the bad guy."

Friends gave one excuse or another for not repaying. Mittleman, 22, is out the money, and the friendships have suffered. He vows not to lend again. "There is not a chance in the world I could trust anybody," he says.

Loans to friends and relatives are dicey. You can play it safe by saying no to all loans or offering the money as a gift without expecting to be repaid. But if you do decide to play banker, set some ground rules for yourself and the borrower.

• Never lend more than you can afford to lose. That way, if the borrower defaults, you haven't put your finances in jeopardy.

• Make the loan as businesslike as possible, drawing up a promissory note that both of you sign. The note should contain loan details, such as the amount borrowed, the interest rate and repayment terms. Discuss what you'll do if the borrower can't repay.

Indianapolis financial planner Grace Worley says some parents worry about favoring one child over others by making a loan. To be fair, some execute a promissory note so there's evidence of the loan to a child, and when the parents' estate is settled, the loan is subtracted from that child's share, she says.

The IRS requires that you charge interest if the loan is more than $13,000, the amount one person can give another this year without triggering gift taxes, says Cindy Hockenberry, research coordinator with the National Association of Tax Professionals.

The IRS publishes minimum rates to charge, depending on the length of loan. The annual rate for loans of less three years is 0.6 percent.

If you're talking big sums, consider having a lawyer draw up the paperwork.

Besides the promissory note, you can seek a security agreement that will allow you to stake a claim against some of the borrower's assets if he or she defaults, says Mitchell Rothenberg, an associate with Bowie & Jensen in Towson, Md. You can also set up a "guarantee," where someone else agrees to repay the loan if the borrower defaults, he said.

Another option gaining in popularity is the peer-to-peer lending site Virgin Money, which acts as an intermediary for loans between friends or relatives. The site's outstanding loans doubled in the past year to $280 million.

Under Virgin Money's Handshake Plus program, you can set up a promissory note with a borrower. Virgin Money will electronically debit payments from the borrower's account and forward them to you. If the borrower doesn't repay, collection action can be taken or the default could be reported to the credit bureaus. Usually, though, families revise the loan terms if a relative is struggling to repay, says Asheesh Avandi, chief executive of Virgin Money USA.

The cost is a one-time fee of $199, plus $9 per payment. It might be worth it to keep a relationship.

"We like to say, 'We make Thanksgiving comfortable,' " Avandi says.

Not all lending stories end well. And if yours doesn't, you might be able to get some consolation by writing off a bad loan on your tax return.

To pass muster with the IRS, it must be a bona fide loan, meaning you have a written agreement and both parties have signed the pact, Hockenberry said. And you must be able to show that you took steps to try to collect the money — a trip to small-claims court, say, or letters from you or a lawyer seeking to wring out payments from the borrower, she says.

Losses on loans can be deducted as a short-term capital loss, the same way you write off investment losses, Hockenberry says.

Dos and don'ts in lending to family members 02/28/09 [Last modified: Saturday, February 28, 2009 3:31am]
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