Family loans: The good, the bad and the ugly
In this article, we shed some light on the adage that ‘family and money don’t mix’ by setting out the top seven things to consider ahead of making loans to family members.
Family loans occur for all sorts of reasons. Maybe your brother approaches you for a loan for his business, or you’re thinking of offering to help your child buy a house, or your cousin has fallen on some tough times. However, before putting your hand in your wallet, ask yourself some important questions:
It may be an awkward thought straight off the bat, but the first question must be, ‘Can I afford to lose this money?’. No one wants to think about losing money, especially in this economic climate. That is exactly why this needs to be the first consideration when contemplating a loan to a family member. It should not be viewed as questioning the motives of the borrower or the lender; it should be a simple question of fact.
Put differently perhaps: ‘How long can I live without this money?’. Prior to making any loan to a family member it is worthwhile getting advice from an accountant or a financial planner if you are not sure about the answer to this question. By undertaking this analysis up front you are not only safeguarding your hard-earned money but also safeguarding the relationship from a future fall out if the borrower is not able to pay it back as and when intended.
Believe us, this is a question that is as important in life as it is in death. Initially, it is important to ensure that the expectations of both parties are clear up front. Do you intend for the loan to be repaid, whether by a series of repayments or in full at the end of the term, or are you gifting the money to the borrower? Loans typically have a repayment date and attract interest, but gifts are not expected to be repaid. We are of the view that if you will be loaning the money to a family member, it must be documented, even if by a simple loan which sets out the essential terms in a few pages. This not only protects the lender, but it can also protect the borrower.
For example, if the loan is to a child for the purchase of a property, putting together a formal loan document may well be beneficial in safeguarding the money loaned from being caught up in any family law proceedings in the event of a future separation. There have been instances where loans have not been documented and so have not been taken into account in the division of assets in divorce proceedings.
It is always possible to document the loan and later forgive the loan at the lender’s discretion, subject to any tax advice.
Speaking of tax, it is worth noting the Australian Tax Office generally does not impose tax on gifts and inheritances. However, if the loan was provided for an income-generating activity, the borrower may be liable to pay tax on any profit resulting from the loan. A lender on the other hand may pay tax on any interest received on a loan.
Ensuring loans are properly and carefully documented could well mean avoiding a family implosion after your death. Imagine this, you loan money to your eldest child without the knowledge of your other children. Some years later you die and your eldest child claims that the loan was a gift and is not repayable to your estate – your other children are furious. Imagine instead, the same scenario but that when you gave the loan, you also carefully documented it. This time, all the children knew exactly what the arrangement was, and a dispute was avoided.
In most cases the purpose of the loan will dictate whether the lender should take security or not. As a lender, you are entitled to know what the purpose of the loan is. If the loan is to assist with purchase of a property, then it may well be worthwhile to secure the property (and in turn your interest in the property to ensure you are repaid), especially if there is another lender involved. This is often the case if a loan is used for the deposit on a property while the balance will be sought from a bank.
If, for example, the loan is to assist with the repayment of debt, there are a few other considerations, including whether you trust the financial state of the borrower and whether there are any assets of the borrower to secure. Again, it depends on the circumstances but should certainly be considered ahead of advancing a loan.
There are a few instances where a loan may be challenged by a third party who would like to disprove that there was a formal loan in place. The most common instances are:
When lending money to a family member, it is important to seek both financial and legal advice to reduce the risk of the loan being challenged later.
No matter how brief the loan is intended to be in place, the effect of the death of one or more parties to the loan should always be a consideration. As briefly mentioned above, in instances where a parent loans money to a child, for example, it needs to be considered how the loan will affect the rest of the beneficiaries in the event the parent dies. Lenders should consider whether the loan will be forgiven, repaid into the estate or whether it will it simply be deducted /offset from the child’s share in the estate.
Conversely, in the event the borrower predeceases the lender, does the borrower have sufficient assets to ensure the loan is repaid? If this is not clear, it is possible to manage this risk by including an obligation in the loan agreement for an insurance policy to be taken out to ensure the repayment of the loan.
Whatever the agreement between the parties, it is important that careful consideration be given to impact of the loan on estate planning documents. Failure to contemplate a loan in a Will may mean that the testator’s wishes are not carried out. If, for example, the lender intended for the loan to be forgiven on death but fails to document this intention in their Will, then the executors of the lender’s estate may require the repayment of the loan to the estate.
As Centrelink pension payments are dependent on income and assets, any changes to a lender’s assets and income may affect the lender’s Centrelink entitlements. Centrelink have restrictions on disposing of assets by gifting them to family members to influence their eligibility for pension payments or aged care costs.
It is presumed under law that money transferred from a parent to a child is an advancement, meaning that the law will presume the money provided to a child from a parent was a gift unless the parent can prove otherwise. The onus is on the parent to prove the transfer was a loan and not a gift.
Centrelink allows for a portion to be given away over a period before it affects a pensioner's entitlements. It is considered a gift if an older person sells or transfers an income or asset and gets less in return than it was worth. A loan is exempt from the gifting amount and will not affect the lender’s pension entitlement. However, Centrelink requires that the loan be documented for it to be considered genuine. If a loan is forgiven by a lender, or if an older person acting as a guarantor pays off somebody else’s loan, the amount forgiven or repaid may be included in the assets test.
Here are some top tips when considering whether to enter into a loan arrangement with family:
If you would like any further information about loans to family members, please contact Kimberly Eichorn, Senior Associate in our Banking and Finance team or Rebecca Edwards, Senior Associate in our Estates and Succession team.