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Watch Out for Implications of Family Loans

So how does one go about properly structuring and documenting a family loan? A family loan for a mortgage done right should include:

  • A promissory or mortgage note that bears a minimum interest rate equal or greater than AFR (the long-term rate is now 2.67%) and spells out its term and payment dates, meaning it must be decided whether payments are to be monthly, quarterly or annually.
  • A mortgage or deed of trust properly recorded with correct governmental authority, which makes the mortgage secured and gives the lender the legal right to foreclose.

The income tax implications for a properly documented and recorded mortgage:

  • The lender records mortgage interest as income on Schedule B of their return.
  • The borrower can deduct mortgage interest expense as an itemized deduction.

Before making a family loan, several other issues must be considered, including whether the borrower is a spendthrift unlikely to pay you back. What is the overall family dynamic? Will you help out other family members in a similar fashion, and if you do not will that create bad blood? You need to tread carefully and consider all of these things before actually making a family loan.

People interested in making a family loan should engage financial and tax professionals to help on the front end. This is not an area to dabble in with forms from the Internet.

>To submit a news tip, email: tips@thestreet.com.

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Michael Maye is the founder and president of MJM Financial Advisors (www.mjmfinadv.com), a registered investment advisory firm in Berkeley Heights, N.J. He is a member of the National Association of Personal Financial Advisors (NAPFA) and has been a speaker covering tax topics at NAPFA's national and regional conferences. Maye has also been a frequent contributor to the Star Ledger of New Jersey's "Biz Brain" and "Get With the Plan" articles. In addition to NAPFA, he is a member of Financial Planning Association, American Institute of Certified Public Accountants, New Jersey State Society of CPAs and the Estate Planning Council of Northern New Jersey.
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