Key Takeaways:

  • Before providing any significant financial support to your children or other family members, it’s best to consider simple strategies first—can you simplify by giving money no-strings-attached?
  • If you decide to loan money to family, it is essential to include your legal and tax advisors to assist with the formal implementation of the loan.
  • Key elements of a successful family loan include clear documentation of loan terms and payment records, charging an appropriate interest rate, as well as factoring in family dynamics and how a specific loan fits in with your current estate plan.
  • Saling Wealth Advisors can help review your options for providing support to family within the broader context of your total financial picture.

Many of our clients aim to provide some level of financial support to their children, grandchildren, and other extended family members. If this planned support is significant—either significant to the clients’ overall financial picture or significant compared to gift and estate tax exemptions—we always encourage reviewing the pros and cons of various methods for helping a family member.

One method that many clients like to consider is loaning rather than gifting money for support. Loaning funds can be appropriate in some circumstances, but there are several key factors to consider when planning for and implementing a loan to family members.

Loan Money or Gift Money Outright?

Before diving into the details of how to best structure a family loan, we always like to take several steps back to determine the underlying purpose for providing support. A loan can be messy with lots of details to juggle, so it’s important to first consider whether making an outright gift, or a series of planned gifts, could accomplish the same goal without needing a formal loan.

As an example, a client’s young adult daughter was looking to buy her first home. The client wanted her daughter to start off in a nicer home in a more desirable neighborhood than she would be able to afford on her own. In this case, rather than establish a formal loan agreement, the client decided to make an outright gift to her daughter during the home search to help bolster her down payment. The client also provided additional cash gifts over time to help reduce the cost of ongoing house payments.

One advantage to the approach of gifting over time is it allows a child to demonstrate their responsibility using the gifted funds as intended. The parents can witness their child’s prudence (or lack thereof) with smaller upfront commitments and adjust accordingly. In contrast, it’s difficult to call back a sizeable family loan if things aren’t going as expected.

Potential Benefits of Loans to Family

If outright gifting or some other method of support doesn’t quite fit a client’s situation, there are some circumstances where loaning money to a family member can make sense. For a different client, his daughter had the opportunity to start her own business, but she could not obtain traditional financing from a bank to make it through the initial start-up stages. The daughter is very capable and experienced in her field and wanted to do as much as she possibly could on her own. She just needed some initial capital and was willing to take on the risk of borrowing to get her business off the ground. For this case, a loan from our client to his daughter had several advantages:

  • A loan met the wishes of the daughter who was not looking or asking for an outright gift.
  • The client was able to step in and provide a loan when a bank was unwilling.
  • Compared to a bank loan, the daughter could access loaned funds on a faster, less formal timeline and sidestep lengthy procedures like underwriting.
  • Since the terms of a family loan can be very flexible, our client was able to charge a reasonable rate of interest and outline a timeline for payments that fit with the circumstances of his daughter’s business.

Loan Documentation is Key

If loaning funds is an appropriate strategy for providing support, there are several key elements needed to establish a successful family loan (hint…it’s more than just writing a check):

A written, signed loan agreement

  • It’s best to have a qualified attorney prepare and review the agreement.
  • A loan agreement doesn’t have to be 25 pages long, but it needs to make clear all the basic terms like the amount of the loan, payment periods, payment amounts, and interest charged.
  • A loan agreement should also cover important contingencies like what happens if payments are late or missed, what happens if one of the parties dies, etc.
  • Another important decision tied to the agreement is whether or not the loan will be secured by any underlying asset (for example: assets of a business or a real estate property being purchased.)

Documentation of the payment schedule and documentation as actual payments are made

  • This includes keeping track of how much interest has been paid and if or when there are any updates or adjustments to the payment schedule.

Documentation of final release

  • Once paid off, it’s typically a good practice to have the lending party formally sign a final release stating that the underlying loan has been satisfied, no further payments are due.

Other Cautions for Loans to Family

In addition to keeping proper documentation, other cautions to keep in mind are specific to a chosen loan structure and, more broadly, considering implications for family dynamics:

Loan Specifics

  • If a loan’s interest rate is below the market interest rate, part of the loan/payments may technically be considered a gift for gift tax purposes.
  • Each month the IRS publishes what they consider to be acceptable market rates of interest, so if you set a loan at or above this “Applicable Federal Rate”, you can minimize the potential gift tax issue. (Of course, this also assumes you follow all of the other formalities for the loan like making actual payments, keeping clean records, etc.)

Family Dynamics

  • What is the true risk that a family loan will not or cannot be paid back fully?
  • Would missed payments cause friction between family members?
  • Is your personal cash flow plan relying on timely loan payments for future spending needs?
  • Is the family member capable of paying back the loan, or could this initiate a pattern of borrowing that might hold them back from achieving their own financial independence?
  • Does making the loan generate extra pressure to provide similar loans to other children or family members?
  • If something happened to you or the borrowing family member, how is payment or forgiveness of this loan treated and does this match the intention of broader estate plans?

How Saling Wealth Advisors Can Help

Please reach out if you are considering any significant financial support to your children or other family members. Together we can review your options, which may demand strong consideration for simple, but effective outright gifting strategies.

Sometimes, your circumstances may indicate that a family loan would be an effective means for providing support. If you decide to move forward with making a loan to family, you will need your legal and tax advisors to assist with the formal implementation. Your Saling Wealth Advisors team can help review the broader decision in context of your total financial picture. We can also provide real-world examples of what we have seen work—and not work—for other family loan situations and help push the coordination of implementation.

Jeffery Gough, CFP®

Senior Wealth Advisor

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This material is not financial advice or an offer to sell any product and is not a recommendation to buy or sell any particular security. The opinions expressed are those of the Saling Wealth Advisors’ Management Investment Team and are subject to change without notice.

Saling Wealth Advisors (“SWA”) is an independent SEC registered investment advisor. Registration does not imply a certain level of skill or training. This material is provided for informational and educational purposes only. More information about SWA including our advisory services, fees, and objectives can be found in our Form ADV Part 2A, which is available upon request.

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