You have the money and your child needs a loan. The rates for student loans or for a car loan are high. Should you be the bank? Should you or can you loan your child money?
Yes. You can. There are times when an outright gift is not appropriate. You may feel that it is appropriate for your child to earn what he or she desires. If you are financially able, then a loan is an option.
There are some requirements that must be followed to be in line with the IRS and with Estate Planning concepts as well. The loan must be in writing and must specify the amount of the loan, the interest being charged, the time over which it must be paid.
Why should it be in writing? If challenged, you must be able to produce a document that is written and signed by the parties. Additionally, if you pass away prior to the loan being paid off, it could be ignored by the child. This could change the distribution of your estate by giving a windfall to one child over the others.
Why should there be interest? If there is no interest on the loan, it is a gift. There are minimum amounts of interest that must be charged for the loan to qualify as a loan for IRS purposes. These interest rates vary and you must check to find the correct minimum at the time of the loan.
How to treat the interest? This is a loan and the interest that is paid is income to you. It must be claimed on your income tax return.
Can the loan be forgiven? If the intent from the beginning is to forgive the loan, then it does not qualify as a loan. It is a gift. If however, due to a change in circumstances, you decide that a part of the loan is to be forgiven, then it is permissible. To the extent that the loan is forgiven, it is a gift and if over the threshold amount, must be claimed on a gift tax return. You may also state in your estate plan that unpaid loans are forgiven and are not be counted as a portion of the distribution of your estate.
As long as you follow the rules, it is possible to be the bank and loan your children money. It simply must be written down and above board.