The right way to loan money to family members

For right now, we'll just focus on the mechanics of doing it right.

Setting clear terms and communicating them is essential, said financial planner Victoria Collins, co-author of "Best Intentions: Ensuring Your Estate Plan Delivers Both Wealth and Wisdom."

Among the items you should cover:

Be clear (to the borrower, at least) that you expect to be paid back. This is particularly important if previous loans turned into gifts, inadvertently or otherwise.

You should discuss how much the payments are to be and when you should expect them. You also might talk about what will happen if the borrower is late or misses a payment.

Regardless of what you tell the borrower, though, Ramsey believes you should be prepared in your own mind for default.

Most of the time, she said, "they wouldn't be asking you for money if they could manage money in the first place."

Get good tax advice. Interest paid on family loans is taxable to the lender. But not charging interest may not be the right solution, since there's a tax bugaboo called "imputed interest" that can cause headaches for people who lend money to relatives.

If you don't charge interest, or don't charge enough, the IRS can essentially decide to tax you on income you didn't actually receive from the loan, said Mark Luscombe, an analyst for tax research firm CCH. Also, loan amounts you forgive may be considered taxable income to the borrower.

There are loopholes big enough for most families to get through, but if the loan is for more than $10,000 or your family has made other gifts or loans recently, you'll probably want a tax pro's advice.

Draw up a contract. You can find contracts for promissory notes in stationery stores, or you can download forms from suppliers like Nolo Press for a fee. (Nolo also publishes a book, "101 Law Forms for Personal Use.")

Or you can just type up a statement that discusses how much you're lending, at what interest rate, the due dates for the payments and the other details you worked out. Make sure both parties get and sign copies.

Consider recording a mortgage debt. If you're lending money to buy or refinance a home -- particularly if it's a large amount -- consider having the debt officially recorded with the county clerk as a mortgage against the house. That will allow the borrower to deduct the interest on the loan, since the debt would be secured by the home, and gives the borrower the option of foreclosure.

Recording fees vary by country, but are usually somewhere around $200. Your county clerk's office should have information on how to record a mortgage debt, although many people hire attorneys to do the work.

Finally, and perhaps most importantly:

Don't lend money you can't afford to lose. Let's face it, even if you had the option of foreclosure, you probably wouldn't use it. That means you should avoid loaning money you can't live without, and you shouldn't let the rather healthy possibility of default ruin your relationship with the borrower.

"You could have a loving and deep relationship, and all of a sudden you're not speaking," Ramsey said. "The chances of it going sour are much higher than not . . . be prepared for that."

Liz Pulliam Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "Your Credit Score: Your Money & What's at Stake." Weston's award-winning columns appear every Monday and Thursday, exclusively on MSN Money. She also answers reader questions on the Your Money message board and helps middle-class families cope at Building a Brighter Future.

Updated Nov. 18, 2009

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