Loaning Money to a Friend: The Tax Implications You Need to Know

Loaning money to a friend or family member can seem like a kind gesture but it can also lead to some tricky tax situations. As the lender you need to be aware of the tax rules around gifting money versus lending money, as well as how to structure the loan properly. Failure to do so can result in you owing taxes on the loan amount or having it count against your lifetime gift tax exclusion.

In this article, we’ll break down the key tax implications to understand when loaning money to a friend. Whether you’re considering a small, short-term loan or a larger sum, you’ll want to go into the agreement with eyes wide open to avoid any surprises at tax time.

Is the Money a Gift or a Loan?

The first question to ask yourself when providing money to a friend or family member is whether this is truly intended to be a loan, or if it is more of a gift. This determines how you will need to handle the transaction from a tax perspective.

Here are some differences between gifting money versus loaning money

• Gifts do not require repayment or interest. The recipient is not obligated to pay you back in any way.

• Loans are made with the expectation of repayment, usually with interest. The borrower is legally required to repay the lender per the loan terms.

• Gifts over $15,000 per year may require filing a gift tax return. Loans typically have no gift tax implications if structured properly.

• You cannot deduct gifts as losses if they go unpaid. Unpaid loans may be deductible losses depending on circumstances.

So before providing the money, decide whether this is a no-strings attached gift or a loan that establishes a lender-borrower relationship. This will dictate the tax treatment.

Gift Tax Rules to Know

If you determine that you do want to gift money to a friend with no expectation of repayment, you still need to be aware of gift tax rules. Here’s what you need to know if gifting over $15,000:

• The annual gift tax exclusion for 2023 is $17,000 per individual recipient.

• You need to report gifts exceeding $17,000 for the year using IRS Form 709. This applies against your lifetime gift and estate tax exemption.

• Married couples can jointly give up to $34,000 gift tax-free due to gift splitting.

• Direct tuition and medical expense payments are not taxable gifts regardless of amount.

• You are responsible for reporting and paying any gift tax due, not the recipient.

The key is that gifting over $17,000 in a year requires filing a gift tax return. But no actual gift tax is owed until you have exceeded your $12.92 million lifetime exemption.

Requirements for a Tax-Free Loan

If you want to avoid gift taxes by structuring the money as a loan, you need to meet certain IRS requirements:

1. Written Loan Agreement

The first requirement is having a written loan agreement defining all the key terms. This can be as simple as a promissory note. Key terms include:

• Loan amount
• Interest rate
• Payment due dates and amounts
• Collateral or guarantees (if any)
• Loan term and maturity date
• Default remedies

Having this agreement protects you in case the borrower fails to repay on schedule. It also demonstrates to the IRS that you intended and documented the money to be a loan.

2. Minimum Interest Rate

You must charge at least the Applicable Federal Rate (AFR) as interest on the loan for it to be tax-free. The AFR varies based on the term and compounding period:

• Short-term (3 years or less): 4.91%
• Mid-term (3 to 9 years): 4.72%
• Long-term (over 9 years): 5.04%

These are the minimum rates as of February 2023. Go below these rates, and the foregone interest can be considered an additional taxable gift.

3. Regular Payments

The borrower needs to make payments on a regular schedule, at least annually. Irregular payments or letting interest accrue can make the IRS see it as more gift-like than a loan.

4. Secured Loan

Ideally the loan should be secured by collateral belonging to the borrower. This demonstrates it is a valid lending arrangement between you and the borrower.

By meeting these requirements, you can provide over $17,000 tax-free as a loan rather than a gift. Just be sure to report any interest income received on your personal tax return.

Consequences for Non-Repayment

What happens from a tax perspective if your friend never repays the loan? Here are some key points:

• You cannot deduct loan principal as a loss, only unpaid interest and fees.

• If you forgive the debt, you must report it as a gift on Form 709 for that year.

• The borrower may owe income taxes on any amount you forgive over $600.

• You can charge off an uncollectible loan as a bad debt if you have made reasonable repayment efforts.

So if your friend defaults, you either have to forgive it as a now-taxable gift or write it off as a bad debt for potential deduction. Make sure your loan agreement gives you the ability to pursue legal remedies for non-payment.

The $10,000 Tax-Free Gift Loop Hole

There is one tax loophole to mention when loaning money to family and friends. The IRS does not require formal loan agreements for loans under $10,000.

So you can loan a friend up to $10,000 with minimal documentation and no AFR interest rate without triggering gift taxes. Just be sure to report any interest received still, and get some documentation signed for safety.

While this provides more flexibility for smaller loans, it is still advisable to follow the proper loan structure where possible for your own protection.

Tips for Loans to Friends and Family

When providing money to friends or family, keep these tips in mind:

• Consult a tax pro or financial advisor if loaning significant sums. A few hundred dollars is lower risk.

• Only loan what you can afford to be without if the borrower defaults. Don’t put your own finances in jeopardy.

• Consider alternatives like co-signing a loan from a financial institution instead of lending yourself.

• Have an honest conversation about whether this is a gift or a loan upfront. Get it documented either way.

• Follow up at tax time regarding any interest received or gift tax returns required.

• Approach mixing friendships with finances cautiously to avoid strained relationships if things go south.

The Takeaway

Loaning money to friends or family can be fraught with tax complications. Small, short-term loans under $10,000 are generally tax-free. But for larger sums, take steps to formally document the loan and charge AFR interest rates. This helps avoid potentially owing gift taxes on the transaction. Just remember to report interest income and gifts properly at tax time. With the right preparation, you can make an informal loan to a friend without getting dinged!