Not only to avoid any misunderstanding should you document your loan terms clearly, but also to keep the tax man from your creditors doors. This will avoid them from paying income tax on interest never received. Having the lender write a memo that you were solvent at the time of the loan saves them from incurring any gift tax liabilities.



While most family loans are interest free, the IRS doesn't take happily to such situations and arbitrarily imagines an interest rate for which they charge tax to your creditor. Further, since you have not paid any interest, they consider it as a gift from the lender and add gift tax liabilities! This can all be avoided with some good planning.

If the loan (including interest) between you and the creditor less than $10,000 you won't face these complications. However if the loan amount is more than $10,000 you can save yourself trouble if it's less than $100,000 and your net investment income for the year is less than $1000. To qualify for this, the lender should collect an annual statement that mentioned the borrowers net investment income.

If you are borrowing money to make the down payment on your new home, it is important to legally secure the note with your residence. This way you can take advantage of tax deduction by way interest paid on home mortgages.

To further avoid any gift tax issues you should get your creditor to give you a demand loan. A demand loan is one where they can demand repayment at any time and although this seems risky, you can have an informal arrangement for avoiding the same. Issues regarding a demand loan can be a little tricky sometimes so it is best to enlist the assistance of a tax lawyer.

Finally, get a clear picture of the tax implications if you default. While it will certainly hurt your family relations, it will also affect your creditors tax liabilities. So if your lender tries to write off your bad debt on their tax return, the IRS will look to collect the lost tax from you!