Family Matters: Lending to Your Children
Have you ever considered lending money to help your child with a down payment on a new home, to bankroll a business venture, or for some other major expense? Many adult children seek financial assistance from their parents if they encounter difficulty securing a bank loan because they lack a credit history or collateral. Often, parents want to help their children succeed in life and are willing to give them a financial boost. In general, parent-to-child business loans tend to go smoothly. However, if a loan is not paid back as agreed upon by both parties, it could affect family relations. So, here are four points to consider before lending funds to your child:
1. Document the loan. If you expect the money to be repaid, consider treating the loan as seriously as a bank would by requiring the proper documentation. You must be able to demonstrate to the Internal Revenue Service (IRS) that you made a bona fide loan in order to deduct it as a bad debt. For tax purposes, request the following:
• A note and written loan agreement
• Collateral or other form of security
• A repayment schedule and repayment records
• A plan indicating that the loan will be repaid as scheduled
• Proof that a business was solvent when the loan was made, if applicable
Proper documentation may also help you avoid other complications. For instance, if your child were to divorce, a written loan agreement identifying who is responsible for repayment, and on what terms, could prevent a former spouse from refusing responsibility for the debt or claiming that the money was a gift. It could also keep an ex-spouse from obtaining—through the division of marital assetsa controlling interest in a company you funded.
2. Know the rules. The IRS allows you to deduct bad debts only after you have tried to collect them by legal means, if necessary. So if you want to write off the loan, you must be prepared to take legal action to collect it.
If legal action is appropriate in your situation and you are still unable to collect the loan, you may write it off as a short-term capital loss by subtracting the outstanding loan balance from your total short- and long-term capital gain for the year. If the loss exceeds your total capital gain, you may deduct it in $3,000 increments each year until it is entirely written off.
3. Treat the bad debt as a gift. Instead of a lawsuit, you may have the option of treating the bad debt as a gift. In 2015, the IRS allows each taxpayer to give up to $14,000 per person per year free of gift and estate taxes. Thus, both parents together could offset an uncollectable debt with a combined gift of up to $28,000 per year with no tax consequences. (Any amount exceeding this limit may be subject to gift and estate taxes.)
4. Use common sense. Lending money to a child may have certain tax consequences for you, so it is important to consider the odds of a successful follow-through on your child’s part. Think twice before lending money for a risky venture unless you are willing to part with it as a gift with possible tax consequences, if needed.
Helping a child to succeed in life can be an exciting and rewarding experience for a parent. But, be aware of potential tax traps and legal pitfalls before opening your checkbook, and remember to seek professional advice beforehand.
The information provided is not written or intended as specific tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. MassMutual, its employees and representatives are not authorized to give tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel.
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