If your friend or relative doesn’t pay you back, you could potentially receive a tax deduction and write it off as a non-business bad debt. However, you must document the loan properly by showing the IRS that it was a loan, not a gift.
A family member or friend asks to borrow money; we’ve all been in that situation. They give you a sob story and swear on their distant uncle’s grave that they will repay you. It’s easy to refuse when the money is for a dubious transaction, but it’s nearly impossible to refuse your sister who needs to get back on her feet after a nasty divorce.
You have several options. You can be Good Samaritan and gift them the money, stick to your principles and say “no” or you can lend them the dough.
Before you go through with it, be prepared for the reality that you may have to write off the debt for the sake of your relationship.
To improve your chances of getting paid back:
1.Treat it as a business transaction. Have them sign a promissory note with specific terms that cover the repayment amount, interest rate, how payments will be made and how late payments will be handled. The more the agreement spells out terms, the less need for you to go knocking on their door to collect. If that feels awkward, just blame it on your accountant. This will tell your friend or relative that they are taking on a real financial obligation and you expect to be paid back. Online providers such as Zimplemoney.com can take over the hassle of managing the loan. It offers loan agreement templates that can be customized, handles payment transfers directly to your account, tracks payments and will even email payment reminders.
2.Charge a reasonable interest rate. At the very least, you should charge the Applicable Federal Rate (AFR) — set by the IRS for tax purposes. The IRS publishes AFR rates on its website, IRS.gov. Consider charging a slightly higher rate as compensation for the inconvenience of parting with your money for a while. Hopefully it will motivate your friend or relative to repay the money quickly.
If you are thinking about lending someone a large sum of money, it would be wise to consult your tax advisor first.
If your friend or relative doesn’t pay you back, you could potentially receive a tax deduction and write it off as a non-business bad debt. However, you must document the loan properly — showing the IRS that it was a loan, not a gift. You will need to prove that you made a reasonable attempt to collect the debt, including taking legal action against your friend or relative, an unsavory, but likely, possibility. For more information, refer to IRS Publication 550.
Shakespeare had it right: “Neither a borrower nor a lender be” is a well-known quote from Hamlet. Even in the Bard’s day it was considered risky to lend money to friends. It causes resentment on their part and if they cannot pay you back you are doubly out of luck. Not only do you lose your money, but your friends as well. This famous quote can help you in times of indecision, but if loan you must – be sure to back it up with a written and signed repayment agreement.
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