Setting boundaries when lending money

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Deciding whether to loan money to a friend or family member can be a tricky road to navigate. It is important to understand the personal, legal and tax consequences of your decision. When someone asks for financial help, saying “no” can be hard. And, if it’s a family member, it can even be harder.

To help you assess your personal situation, those in the finance world have some suggestions. Although some may seem insensitive, creating financial boundaries, just as you do other boundaries, will be the best decision for all concerned.

Always be sure you can manage the loan, without putting your own financial health in jeopardy. Secondly, get all the terms in writing and consider putting the repayment plan on autopay. You may want to consider charging interest, as well.
While it is possible to make an interest-free loan, IRS rules for doing so are complicated.  If you assess a below-market rate on a loan greater than $10,000, the IRS may impose taxes as if you received interest income you didn’t collect.  For guidance in determining an appropriate rate of interest to charge on the loan, you can check out the IRS website for Applicable Federal Rates (AFR).

Understanding the legal and tax consequences of a personal loan is very important. For instance, if an older adult lends a significant amount of money to one of his or her children and later has to go into a nursing home and apply for Medicaid within five years and the loan is still outstanding, serious consequences can arise. If the loan can’t be paid off, Medicaid will consider it a “gift” and divestment penalties likely will be applied.

If you struggle with turning down a request for financial help and are concerned with how it may impact your relationship with that person, psychologists who consider such matters recommend writing a script. Practicing with a friend can help. Or, if you are going to agree to the loan, be sure you’re comfortable with the terms and explain them clearly and in writing. This will serve both parties well in the long run.

Of course, the relationship of the borrower will likely influence how you want to respond. If your adult child is looking for financial help that you don’t want to or can’t provide, consider telling him or her that you think it’s best for them to figure out a solution to their situation on their own.

Turning down a family member or close friend who asks for a loan can often be accompanied by feelings of guilt. Just keep in mind, feeling some guilt for a while, beats resenting someone long-term, especially someone you care about. Sometimes, it helps if you can reach a compromise agreement- maybe a smaller loan with a set timeframe for repaying it. But that needs to be your decision.

If you choose not to make the loan, for whatever reason, let that be the end of the discussion. It doesn’t need to sour your relationship. No one’s love, respect and support should hinge on the financial part of that relationship. Conversely, if you decide to make the loan, be sure you’re well-informed about the potential financial impact to you and discuss the situation with your financial professional.

If you are in a position to provide the help that your family member needs, you can make a significant difference at a critical time in their life. Conventional wisdom advises “don’t lend money you can’t afford to lose”.  A 2019 Bankrate survey reports that 37% of Americans who lent money to friends and family lost money. Assuming you have carefully considered your financial situation and are sure that lending money doesn’t put your financial future at risk, why not consider making a gift?  In 2022 individual taxpayers may gift $16,000 per recipient without triggering gift tax.

Making a gift or loan to someone you care about can be a great way of “paying it forward”.  Whatever you decide can have important implications for your financial future. Please reach out to one of our tax advisors to explore your options. We are happy to help.

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