How to Borrow Money to a Family Member

CNN Money posted an article recently about exploring the possibility of receiving a loan from a family member rather than a lending institution. While most people aren't fortunate enough to have enough extra cash to finance a home purchase for a child, if you have a parent that is, there can be significant financial benefits to both you and your parents.

In order to ensure that the transaction complies with tax laws your parents need to ensure that too much of the loan is not forgiven and an appropriate rate of interest applies to the loan. Otherwise the loan could be considered a gift which would lead to uninvited tax consequences. Annually, each parent can gift $13,000 free of tax or $26,000 combined. Anything over this amount would be subject to federal gift tax. In order to prevent that on a loan, your parents will need to charge interest based on the IRS's "applicable federal rate" minimum. The good news is that, even in a down economy, these rates are still well below those being charged by lending institutions. As the borrower, you can still deduct the interest if you use the money to purchase a principal residence. Your parents will need to include any interest received on their income tax return, but the ability to receive income from helping their child is an attractive option to most loving parents with the means to do so. Also, these limitations change annually many years, so they are continually rising with the pace of inflation.

Another positive aspect of a family loan is that payments terms can be much more flexible than those of a traditional mortgage. One example the article suggests is to stipulate that the early payments on the loan be interest only while deferring the payments on principal until later on in the term. This gives you the ability to maximize your interest deduction leading to additional savings. If your parents are feeling extra generous, they have the ability to use that $26,000 combined gift tax exclusion amount towards forgiving your loan each year which can drastically reduce the principal.

You will need to ensure that proper documentation is drafted and executed so that the transaction does not look like a sham. This will typically be done through a Promissory Note or a Line of Credit Agreement. A Promissory Note sets forth the obligations, rights, and duties of both the lender and borrower during the term of the load. This would typically include the payment terms, interest rate, when payments are due, the time and manner in which the principle of the loan will be distributed to the borrower and warranties by either or both party that they are able to enter the agreement and and not making any false statements in applying for (or in the case of a family loan, asking for) the loan. A Line of Credit Agreement will set forth the same items, however, it is the structure of the borrowing that varies. With a Line of Credit, the borrower can take funds from the lender in specific amounts at specific intervals or in varying amounts in varying intervals. This allows flexability for the borrower to reassess the need for the funds throughout the period of the Line of Credit Agreement.

For example, say that the borrower would like to borrow $3,500 a month while he gets his business up and running, but he is not intirely sure when he will be able to rely solely on the income from the new venture. He could set up a Line of Credit Agreement with his father that would permit him to borrow funds at will in varying amounts depending on need for a period of two years. The agreement would also stipulate that the total amount borrowed could not exceed $50,000. This would give the son the flexability to build his business, and as it grows more successful, borrow smaller amounts against the line of credit from his father. If the business is up and running in one year and the sone has only borrowed $25,000, he would only need to pay the interest and pronciple on the $25,000 instead of the entire $50,000 originally contemplated. The key to this sort of arrangement is that the father commits to lending the entire $50,000 and the son has a right to that money any time, even if that means he takes all of it in month one (unless, of course, monthly limits are set on what may be withdrawn).

If you abide by all the necessary formalities, a family loan can provide numerous benefits that a traditional mortgage from a lending institution cannot. For more information on the benefits of a family loan and issues to be aware of in setting one up, contact me or another business attorney or financial advisor.

Michael F. Brennan runs a virtual law office helping individuals in Wisconsin, Illinois, and Minnesota with estate planning and business law issues. He can be reached at michael.brennan@mfblegal.com with questions or comments, or check out his website at www.thevirtualattorney.com