The wealth gap between your clients and their adult children is big enough that the older generation may have both the ability and the desire to help their kids or other family members out with a larger loan.
That can be a great idea, but there are potential pitfalls beyond just the worry over the lenders getting their money back—especially if multiple generations and siblings are interested or affected. Here’s how your benevolent clients can serve as the “family banker” and avoid as much acrimony as possible.
Contemplate, Then Communicate
The first step to solving problems before they arise is for your clients to formulate a policy addressing if they’re going to lend money to their younger family members, how much they will lend and for what purposes.
For example, if your clients are parents with three children, the clients should expect that if they lend money to one child, the other two may ask to borrow some now or down the road.
In this situation, you and the clients should agree on a total portion of their portfolio that would be suitable for future lending to their three children (without jeopardizing the parents’ financial security if the loan isn’t repaid) and lend no more than a third of that amount to any one of the children.
Whether the “cap” is financially or philosophically motivated, it can also help prevent chronic borrowers from returning to the parental money well too many times. (“If I lend more money to you now, I’m obligated to help your siblings out in the same way, and our financial advisor says we can’t afford to do that.”)
Once the clients have agreed upon the parameters of their lending, they should meet with the adult children to talk about the opportunity to borrow money, the amount available, suitable reasons to request the family loan and the terms of any future agreements.
Write It Down
Once a particular loan is agreed upon by the parents and children, it’s important that both parties create a formal agreement, and that everyone involved signs, dates and even notarizes it.
Documenting the loan from the beginning can not only help the borrower and the lender track repayments but also help mitigate potential fallout from other family members (and the IRS).
Ideally the clients and the borrower will contact their respective CPA and perhaps an attorney to discuss the tax and legal ramifications of lending the money, and (hopefully) completing the expected repayments. But at a bare minimum, the clients should use a service like LoanBack to establish the amount of the loan, interest rate and repayment schedule.
If the loan is a mortgage used to purchase a home or other real estate, the clients and their kids should hire an attorney who specializes in real estate transactions to draw up the proper documents. They could also use a more sophisticated (and expensive) service than LoanBack, like National Family Mortgage, to establish the loan, track payments and generate the ongoing paperwork.
The lender may be required to issue an IRS 1098 form to the borrower that details the interest paid, as well as a 1099 form with the IRS to report the interest received (and they should make sure the figures on each form match!).
Protect the Lender
Lenders may want to request being added as lien holders on any substantial property (such as the borrower’s house) to not only have some recourse available if the loan isn’t repaid but also keep the borrower from digging a deeper debt hole without the lender’s knowledge. The clients could also ask to be added as primary beneficiaries on retirement accounts or life insurance until the loan is paid off. If the borrower has no assets or life insurance, she may be able to get a relatively low-cost term policy that would in theory last the life of the loan, with a death benefit equal to the borrowed amount, and the lender as both the owner and beneficiary of the policy.
Deduct From the Inheritance
The clients should contact their estate planning attorney to have language inserted into the wills, etc. that reduces the borrower’s prospective inheritance by any unpaid loan amounts.
The clients should update their estate planning documents regularly (perhaps once a year or so) with any unpaid loan amounts and current balances due.
If the lenders are concerned that the amount borrowed by the family member may exceed the borrower’s eventual estate, they may also want to establish terms that will allow the estate and/or the heirs to continue to receive loan payments from the borrower, even if the lender has died.
Alternatives to Lending
After reviewing all of the documents, reporting the responsibilities and potential perils of making a family loan, your clients might ask if there are any other ways to help their kids out.
The first is by having the borrower approach a conventional lender (i.e., a bank or credit union), with the client agreeing to co-sign for the loan. Then the client doesn’t have to put up any money initially, nor deal with any ongoing paperwork. Of course, the co-signer becomes liable for paying off the loan if the original borrower can’t.
Last but not least, clients can save a lot of headache and hassle by just giving money to the kids. But, the clients need to make sure that they don’t exceed $15,000 per person per year (the annual amount allowed without requiring the filing of a gift tax return).
The clients may want to give equal amounts to each child at the same time, but with the condition that the money can be used only for certain purposes (say, paying off debt, covering college costs or saving for retirement).
Kevin McKinley is principal/owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of Make Your Kid a Millionaire (Simon & Schuster).