Lending money to family often is not a good idea, say many financial experts, but with interest rates at some of their lowest levels in years, families may find it difficult to resist. Family loans also can be a way to pass on part of the family estate. So if you decide to loan money to a family member, proceed with caution, say CERTIFIED FINANCIAL PLANNER™ professionals.

Let’s say you loan money to your son to buy a home or start a business. The IRS may require you to charge a minimal interest rate, known as the applicable federal rate, for the loan. If you charge below the rate, or make an interest-free loan, the IRS may impute the difference as interest earned and consider it taxable income. In some cases, the IRS could characterize the entire loan as a gift, subject to gift tax.

The imputed interest rules don’t apply under certain circumstances: for loans of less than $10,000 as long as the loan is not used to buy income-producing assets, and for loans up to $100,000 as long as the borrower’s net investment income doesn’t exceed $1,000 for the year.

In loans where the imputed interest rules apply, interest rates are set monthly by the IRS and depend on the length of the loan. For example, if you loan money to your son with the plan that he will repay the loan within three years, the minimum annual interest rate you would have had to charge according to the May 2002 rates was 3.21 percent. For loan periods of three to nine years, the annual interest rate was 4.99 percent, and for nine years or longer, the rate was 5.85.

You may choose to forgive some of the interest payments should you not need the cash or your child or relative is facing a tough financial situation. And you probably won’t be liable for any gift tax if you can use the $11,000 annual gift-tax exemption. The catch is to be sure that you don’t agree in advance to forgive the loan or end up forgiving all of the interest payments. Otherwise, the IRS will likely treat the entire loan as a gift subject to gift tax.

Such low-interest loans can be a good deal for the family member. A 5.85 percent annual rate on a loan for a child buying a home would certainly be better than the rate offered by commercial lenders. And the rate could benefit you as well. In May, ten-year Treasuries were returning around 5.2 percent.

Still, even with these potential advantages to your child and yourself, treat intrafamily loans very carefully. Loans gone sour can create much bad blood in families and could end up the courts.

First, is the family member receiving the loan a good credit risk, or does he or she have a history of not fulfilling promises? Lending money for a mortgage might earn you better money that a Treasury security, but the loan isn’t guaranteed.

Second, is the purpose of a loan a sound one? Lending money for a mortgage or perhaps college might be a good idea, while lending money to bail a person out of debt or to start a business is probably riskier. In the case of a business, for example, have the relative seek other sources of lending such as a bank or a venture capital firm. If institutions are unwilling to lend or invest, perhaps there’s a sound business reason they won’t. If they are willing to lend the money, often it’s best to let them.

Draw up formal documents, with generic preprinted documents or, preferably, with the help of an attorney. Put in writing the terms, interest rate, payment schedule and so on, and keep track of all payments. This not only helps all parties treat it as a real loan, it can prove invaluable should the IRS question the loan. Say your child fails to repay you. You may be able to convince the IRS that this is truly a bad loan for which you can claim a bad-debt loss—versus a slick way to transfer some of your estate to your child free of tax—if you can show past payments, efforts to collect, sale of collateral or, heaven forbid, lawsuits filed for payment.

Formal documents can help the borrower as well. A promissory note secured by a mortgage, for example, would allow the borrower to deduct the interest payments (though this may involve additional legal issues and additional expenses such as title insurance).

And don’t just assume that if they don’t pay it back, you’ll simply chalk it off and consider it a gift or an advance against their inheritance. There can be tax consequences and other heirs may resent the loan forgiveness.

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June 2002 — This column is produced by the Financial Planning Association, the membership organization for the financial planning community.