ALMOST EVERYONE has a relative who's perennially short of cash. Or perhaps a child or grandchild who at one time or another need a loan. Sure, you can be generous. But before you write that check, be sure to follow these rules. Loans to family members touch on two areas about which the IRS is especially sensitive: gifts and interest income. 

Document the Loan

The first step to avoiding trouble is to clearly document that the money is actually a loan, with or without interest. The documentation should also include payment terms and the collateral for the loan, if any. Handle these wrong, and you could find yourself paying income taxes on money you never received and gift taxes on money you never gave away. In the long term, the loan could cut into your gift tax exemption ($1 million) and your estate tax exemption ($2 million for 2006-2008).

You don't need a lawyer to draw up the documentation. In fact, you can easily satisfy the IRS with a do-it-yourself document-creation software program.

Secure the Note

One of the most common loans among family members is to a child who's buying a house. In this case, you should take the extra step of legally securing the note with the residence. (This generally does require a lawyer.) Otherwise, the borrower can't take advantage of one of the most popular tax deductions: interest on a home mortgage. Anyone thinking of not reporting a loan should consider this point. Not only could you get in trouble if you are audited, but your child could face criminal charges if he or she falsifies a mortgage application to hide the origin of the loan money.

Establish Solvency

You should also write a memo to yourself establishing that the borrower was solvent at the time of the loan. This proves you had a reasonable expectation of repayment and were not actually making a gift.

Set an Interest Rate

Interest-free doesn't mean hassle-free. Many loans among family members are interest-free. But be careful. If you don't set an interest rate, the IRS, in its family-friendly way, will do it for you. And since that interest would be considered income for the lender, the IRS will happily tax you on the interest payments you never received. You have now entered the hideously complex world of "imputed interest." Essentially, the IRS, eager to raise revenue, has decided that for a loan to be a loan, interest must be paid, and if interest is being paid, someone is making taxable income.

The IRS's enthusiasm does not stop there. Not only does the agency tax you on imaginary income, but it assumes that the borrower could not afford to make the interest payments (he had to borrow money, didn't he?) and then acts as though you gave him the money to pay the interest. Enter the gift tax. So the money you never received but are paying taxes on anyway could also count against your $12,000 annual tax-free gift limit, and if you exceed that, your $1 million lifetime gift tax exemption and $2 million estate tax exemption. This is not all as nasty as it sounds, and in most cases bad results can be avoided with good planning. 

Avoid Imputed Interest

First, imputed interest and all the crazy imputed income and gift tax problems generally do not apply when loans from you to the borrower total no more than $10,000. However, watch out for this: The $10,000 limit applies to all outstanding loans from you to the borrower, including those charging interest. But if the $10,000 rule does not help, you can turn to the $100,000 rule.

The $100,000 rule applies when the aggregate balance of all outstanding loans (interest-free or otherwise) between you and the borrower is $100,000 or less. For income tax purposes, the amount of imputed interest is zero if the borrower's net investment income for the year is no more than $1,000. (Net investment income, which includes interest, short-term capital gains, and certain royalties, but not long-term capital gains, is the figure used to determine how much margin-account interest can be deducted on Schedule A.) Since most people who borrow money from family members are probably not sitting on large investment portfolios, imputed interest can generally be avoided.

Under the $100,000 rule, when the borrower's net investment income exceeds $1,000, imputed interest is limited to the actual amount of investment income. Here is an example: If a mother lends her daughter $100,000 interest-free but the IRS sets an interest rate of 5%, then the mother would have to declare imputed interest payments of $5,000. But if the daughter's investment income is less than $1,000, the imputed interest would be zero. If the daughter earned $1,500 in interest income, the mother would have to pay taxes on $1,500 rather than $5,000.

To qualify for the $100,000 rule, the lender (you) must receive an annual statement that discloses the borrower's net investment income.

Demand a Demand Loan

So far, so good. Unfortunately, the $100,000 rule gets really tricky when it comes to the gift tax. The net investment income rule does not apply here. To minimize gift tax problems, you should designate your interest-free advance as a "demand loan." This means you can demand full repayment anytime you want. While this may seem unduly threatening to your relative, it could save you money because of the way the IRS calculates the imputed gift. You and the borrower can still informally agree on a repayment schedule.

With a demand loan, the amount of the imputed gift is calculated on a yearly basis. Interest payments on all but the biggest loans will total less than $12,000 a year, so the imputed gift for each year the loan is outstanding will fall harmlessly below the $12,000 annual limit for tax-free gifts.

But if you do not designate the loan a demand loan, the IRS will add up all the interest you would charge for the life of the loan and count it as a gift in the year you make the loan. The result could be a relatively large imputed gift that exceeds the $12,000 annual tax-free limit, and also cuts into your $1 million lifetime gift tax exemption and your $2 million estate tax exemption.

These rules can get tricky, though, so it is probably a good idea to consult a tax pro before making this kind of loan. The IRS will let you avoid all these hassles if you simply charge interest on the loan. The IRS uses what it calls applicable federal rates, which change monthly, to determine if the interest rate is proper. If the lender charges at least the applicable federal rates, he simply reports the interest payments as taxable income. You can find those rates on the IRS web site. 

When Uncle Lou Becomes a Deadbeat

There are few things that hurt family relations more than bad debts. But the IRS is not ashamed to get involved. In fact, in some cases, it can make life easier for the lender.

First, if Uncle Lou turns out to be a deadbeat, you want to be able to claim a "nonbusiness bad-debt deduction." This is treated as a short-term capital loss on your Schedule D. You can claim the deduction simply by showing that the loan is uncollectible. You don't have to file a lawsuit or hire a collection agency. However, you should make a written demand for repayment (again, Broderbund's Family Lawyer supplies a format). When that action goes unrewarded, write yourself another memo for the tax file documenting that you tried and failed to collect your money, and preferably include financial information showing the borrower is insolvent. At this point, if revenge is on your mind, look no further than the IRS. A bad-debt write-off costs the IRS money, and the agency does not give up revenue that easily. For each loss, it reasons, someone, somewhere had a gain, and in this case it would be Uncle Lou. The IRS then seeks to collect tax on his income from "debt forgiveness." So while you may be out a few thousand dollars, you can rest assured that the IRS is seeking to extract at least a few ounces of flesh on your behalf.

But what if you haven't been keeping good records and a loan you made goes bad? Can you still get that consolation prize of a big write-off? Quite possibly. A 1995 U.S. Tax Court case illustrates the bare minimum required for a write-off. Here, a father made thousands of dollars in undocumented loans to his 23-year-old daughter, who wanted to open a roller-skating rink.

The skating rink eventually failed, and the father claimed a $35,000 nonbusiness bad-debt deduction, even though no formal collection efforts were undertaken against his daughter. (She had filed for bankruptcy four months earlier.) The Tax Court concluded that the advances were loans because of "loan" notations the father had made on some of the checks, and because he had previously made undocumented loans to family members and friends and had been repaid.