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Use Promissory Notes When Lending to Family and Friends

Loaning money to family members and friends is delicate. Always protect yourself by putting the loan amount, the terms of the loan, and the repayment terms in writing. "Promissory notes" are legal documents that contain the terms of a loan so that there is a legally actionable record of the loan specifics.

Whether for help with a down payment, car loan, or credit card, any type of loan has legal, financial, and tax implications. A promissory note is a written record of the loan agreement. It is important to have in case the IRS ever audits you. You'll need it to take legal action if the borrower defaults. In essence, it's a legally binding IOU.

The Basic Terms of Promissory Notes

There are three very basic things that you should put in promissory notes. Keeping it simple can help calm any fears that friends or family may have about signing the note. The three things to include in promissory notes are:

  • The full amount of money in the loan
  • A loan repayment schedule and due dates
  • The interest rate (if you charge one)

There are several types of promissory notes, but an important distinction is whether the note is secured or unsecured. A secured promissory note is when the borrower secures the loan with property. For example, you could use a friend's car as collateral for the loan. If the friend defaults on the loan, you would then have the property rights to the car. But, you would need to create a security agreement establishing the friend's respective rights to the car, along with the promissory note. If you secure the loan with property, here are some guidelines:

  • Personal property: There is tangible and intangible property. Tangible personal property can be a car, a computer, or a piece of jewelry. Intangible personal property can be something like a patent, trademark, or ownership rights in a business.
  • Real property: Real property typically refers to real estate such as your house or any land you own.

In contrast, an unsecured promissory note does not have any property attached to it. So, if a borrower defaults on the loan, the lender will have to take legal action to recover the amount owed.

How and When the Loan Will Be Repaid

Most people follow one of two ways to repay a promissory loan. Remember to keep it simple and keep it concise:

  • Lump sum payment: Probably the easiest form of repayment is to pay it all back in one lump sum. If you choose to go this route, specify the date that you expect repayment and whether that lump sum includes any interest owed.
  • Installment payments: The other common form of repayment is to simply set up a way for the borrower to pay back the loan within an agreed upon time frame. Typically, installments are monthly payments. If you are charging interest, make sure to apply part of each payment toward the interest owed.

You could also structure a balloon payment system, but this is complex. A balloon payment is a hybrid between paying in installments and a lump sum. The borrower pays in installments up to a certain point at which time they owe the rest of the loan in a final lump sum payment.

Should You Charge Interest on a Loan to a Friend?

It may feel wrong to consider charging interest to family or friends, but if you don't, you're essentially giving them a gift. One of the roles of interest is to maintain the value of the money against inflation. Today, $1,000 is not the same as $1,000 five years from now, so charging a modest amount of interest shouldn't bother the lender or borrower very much. Be aware that your state has limits on how much interest you can charge (commonly called usury laws). Usually, it's illegal to charge rates over 15-20%, but hopefully, you aren't charging your family and friends that much anyway.

The IRS and Interest-Free Loans

If you decide to give the loan without charging any interest, prepare yourself to justify it to the IRS, because it is a gift in the IRS's eyes. The IRS can "impute" interest on your loan, whether you actually charged any interest or not, and force you to report that imputed interest as income. Fortunately, you can avoid this for most small personal loans. This is because the imputed interest is a tax-free gift if the total amount is less than the limit for gift-tax exclusion.

Get Legal Help

Promissory notes are legally binding, and lending or borrowing money comes with many legal implications. So, it's important to review the terms of a promissory note with an attorney. Reach out to a business attorney today.

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