Steps to Document Loans to Friends and Family Members

If you agree to loan funds to a friend or family member, it’s vital to have documentation in place to help ensure you are repaid in accordance with the terms to which you agreed. However, documenting loans to friends and family members is very important for several other reasons. It can help to promote fairness, maintain clarity, prevent misunderstandings, and ensure proper tax treatment. It’s essential to understand that there are a few steps that should be taken to document loans in order to avoid conflicts.

If you are issuing a loan to a family member or friend, here are several steps you should take to document them:

1. Draft a Promissory Note

A promissory note is a financial instrument that outlines the written promise by one party to pay back another a specific sum of money. It generally acknowledges the debt and contains all the terms involved in the agreement. Specifically, a promissory note will include terms regarding the following:

• Parties Involved — The names of the lender and borrower should be clearly stated.
• Loan Amount — The principal amount being loaned should be specified.
• Interest Rate — A reasonable interest rate to avoid imputed interest issues with the IRS should be included. The rate should at least meet the Applicable Federal Rate (AFR).
• Repayment Terms — The repayment schedule should be defined, including the frequency of payments and the term of the loan.
• Maturity Date — The date by which the loan must be fully repaid must be stated.
• Collateral (if any) — Any collateral securing the loan must be described. In addition, make sure to secure the loan with a mortgage or other security agreement.
• Signatures — The borrower should sign the promissory note in the presence of a notary or witnesses to ensure its enforceability.

A promissory note can be secured or unsecured. A secured promissory note describes the collateral that secures the debt or amount of money borrowed. An unsecured note doesn’t involve collateral — if a borrower doesn’t repay the loan, a lender can use standard procedures to collect the debt.

2. Document the Payment Schedule

The next step in documenting a loan to a friend or family member is to specify the payment schedule. Outline the specific dates and amounts for each payment in writing. Be sure to keep records of all payments made, including dates and amounts.

3. File and Record Keeping

Once you have drafted the promissory note and documented the payment schedule, keep a copy of each for your records. Maintain records of all payments that were made.

4. Understand the Annual Gift Tax Exclusion

Significantly, be aware of the annual gift tax exclusion limits when loaning money to a friend or family member. Loans above this amount without proper documentation and interest could be considered gifts, which are subject to gift tax. Additionally, if the loan is forgiven, it must be documented properly — otherwise, it could be considered a gift and might be subject to gift tax.

5. Update Your Estate Planning Documents

If you’ve loaned money to a friend or family member, it’s essential not to overlook this when it comes to your estate planning. Reference the loan in your will or trust documents to clarify how it should be treated upon your death (e.g., whether it should be forgiven or repaid).

Learn How the Gallagher Law Firm Can Help

Properly documenting loans to family members can help avoid potential disputes, as well as ensure clarity and compliance with tax laws. By following the above steps and seeking professional advice, you can integrate these loans into your estate planning effectively. With offices in East Lansing, Mt. Pleasant, Grand Rapids, and Detroit, The Gallagher Law Firm offers professional services for a wide array of estate planning needs, including those involving loans. To learn more about how we can assist you, contact us online or call (517) 853-1500.