My sister and her husband have been in severe financial distress as result of COVID-19. I want to give my sister some money; however, my wife is opposed to it; she believes that we should loan her the money, not give it to her. In order to promote harmony at home, I have decided to loan my sister the money as opposed to giving it to her. I have a few questions about that. The first is, if down the road I forgive the debt to my sister, is there any tax consequences to me or to my sister? My wife also wants to know what happens if my sister and her husband declare bankruptcy; do we lose the money? You should know that we are planning to loan my sister and her husband $50,000 and my wife insists that everything must be put into writing.
First, I agree with your wife that whenever you loan money to family and friends, it’s important that the agreement be put in writing. You do not want any misunderstandings, which can cause family disputes.
With regards to if you and your wife decide to forgive a portion, or the entire loan, there are tax consequences. If you forgive the debt, in effect you are making a gift to your sister and her husband. As a result, there are gift tax consequences. Under our gift-tax laws it is the person who makes the gift, not the person who receives it that is responsible for any tax consequences. The annual gift tax exclusion is currently $15,000. What that means is that you can gift to anyone you want $15,000 each year without any gift tax consequences. Furthermore, a spouse can join in the gift which means husband and wife can give up to $30,000 a year to anyone they choose without gift tax consequences. Therefore, theoretically, if you choose to forgive the entire $50,000 and since the debt is in both your sister and her husband’s name, between you and your wife you can give each one of them $30,000. Therefore, if you forgave the entire $50,000 there would not be any tax issues for you because of the annual exclusion. If down the road you decide to forgive the debt, neither your sister nor you will have any adverse tax issues.
If your sister and her husband declare bankruptcy, more likely than not the loan would be forgiven by the Court, and you and your wife would not be entitled to any compensation. From a tax standpoint, it is possible at that point in time, you may be able to write off the debt as a bad debt. That would be your only course of action, as you would be precluded by law from trying to collect the debt from your sister or her husband.
I know many of you are thinking that it is not fair that someone can go into bankruptcy and have their debt discharged. That may be, but it is what it is. The only way you can protect yourself is if the debt was secured by an asset. For example, when someone takes out a mortgage, the mortgage is secured by the home. Therefore, if someone declares bankruptcy, they may be discharged from having to legally pay on their mortgage; however, the mortgage company would take ownership of the home. Typically, in most situations with family and friends, there is no security interest and thus, the loan is treated as unsecured.
I cannot stress enough how important it is when you loan money to family and friends that you reduce the agreement to writing, and that you have a conversation to make sure it is clear that you expect to be repaid and what the terms of repayment are. I know sometimes these can be awkward and difficult conversations; however, the last thing you want is disputes within the family. Make sure the agreement is in writing and that you have the difficult conversation, so it is clear that this is a loan, not a gift and that you expect the money to be repaid.