Broker Check

Questions to Ask When Clients Want to Lend Money to Children

by Howard Hook, CFP®, CPA 

As published in Financial Advisor on March 19, 2014

One of the more delicate situations that we as financial planners come across is helping clients decide whether to lend their children money when that child comes asking.

Few, if any financial decisions are more personal or emotional then when a person must decide whether to say “Yes” or “No” to a child. Helping clients navigate through these emotional and financial decisions can really help save them from heartache and grief down the road.

The first question to ask your clients is whether they actually want to lend the money. While it sounds like an odd question, many times it leads to a conversation where your client expresses concerns over lending the money. Sometimes clients will respond by asking you if they can afford to make the loan. While your clients may really not be sure they can afford it, sometimes the question is being asked as a way to give them a way out, to allow them to tell their child that their financial advisor told them no. These and other concerns should be addressed ahead of time so your client can feel more comfortable with their ultimate decision.

You should be careful to review the positive aspects surrounding loaning money to a child as well. Helping them buy a house, or attend graduate or professional school, or start a business, can be very satisfying to your client. In some cases, it might also be a prudent decision -- such as taking out a loan themselves to pay off a high-interest student loan while the child faces additional years of training. While some parents believe that children should wait until they are older or more mature, the reality is that people are living longer and thus children are waiting longer to inherit assets from their parents. Loaning money to a younger, responsible child who is likely to repay their parent may just be the push they need to succeed and become financially responsible for themselves.

Once the decision is made that the client wants to make the loan, it is important at that point to determine if indeed he or she can afford it. Reviewing worst-case cash flow and retirement projections with your client can provide comfort or concern depending on what those projections show.

A focus is usually put on whether the loan will be repaid. However, what is equally important to discuss is whether your client can make do in the meantime. Parents may need to sell investments to make the loan, when reduces the amount of income their investments are generating. Some parents may only be able to make the loan by taking a distribution from a 401(k) plan or IRA, which could result in income taxes being owed by the parents. In some cases, such as the decision to pay back a child’s student loan, it might necessitate the parents taking out a loan themselves.

After the first two hurdles are overcome, the next hurdle is formalizing the loan agreement between a client and child. At first blush, it may seem silly to draw up a formal loan agreement. After all, most parents are not going to sue their children for breach of contract for failure to pay. A formal loan agreement, however, is important because it makes the transaction feel “real” for both parties. This can help preserve the parent/ child relationship if things go sour. A formal loan agreement sets out both the borrower and the lender’s expectations ahead of time, making it harder for someone to say they were unaware of any of the terms of the loan.

The loan agreement should be in writing and include the amount borrowed, the interest rate being charged, and the repayment terms. The agreement should be signed by all parties. Interest on the loan should be charged and care should be taken to make sure the interest rate does not run afoul of IRS rules regarding the minimum amount that has to be charged to avoid interest being imputed. The IRS may also say that a gift is being made from the borrower to the lender.

Often times, parents feel awkward having to collect a loan repayment from their children each month. This can be overcome by having the child pay the loan back directly from their bank account to your client’s account. There also are companies that can help facilitate the process to make it less awkward for all involved.

Once the transaction is completed, it is important that any tax consequences to the loan be properly reported on your client’s income-tax return. The portion of any loan repayment that represents interest income is taxable to your client in the year received. Principal payments are not taxable.

What if, after all of the above, the child is not able to repay his or her parent?

The best way to handle this issue is to address it upfront with your client before the loan is made. Is your client willing to write off the balance owed if the child is unable to pay back the loan? While it may not affect your client’s ability to maintain their lifestyle, it does raise the question of whether it could affect his or her ability to then loan money to other children should they need money. Many people wish to leave their estates equally to their children. However, if a loan to one child is written off, that creates an unequal distribution. Does your client want to gift an equal amount to other children to keep things equal? If so, what effect will that have on the balance of their assets?

From a tax perspective, missed payments cannot be deducted unless the loan becomes completely uncollectible. If that becomes the case, the lender may be able to deduct the uncollected portion as a capital loss on their individual income tax return. The loss works much like a capital loss on the sale of an investment. It can be used to offset capital gains, and up to $3,000 of the loss in excess of any capital gains can be deducted against ordinary income tax. Unused losses can be carried forward to future years.

Any discussion with clients about lending money to children can be fraught with emotion. Yet, it’s the financial advisor’s job to understand the baggage that accompanies this issue and point out the pros and cons to help the client stay clear-headed and practical in making any decisions.