My sister wants to borrow money

If an unreliable family member is asking you for a loan, proceed with caution.

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By Walter Updegrave, Money Magazine senior editor

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005)

NEW YORK (Money) -- Question: My sister and brother-in-law have announced that they are broke, and want to borrow money. They went bankrupt a few years ago, but have since blown two inheritances on high-risk investments. They also borrowed extensively from our parents and never repaid the loans. Although both are college educated, neither has had a regular job for years, and now they say they can't find work. We turned down their loan request, and now my brother-in-law is threatening to never let us see my sister and nephew again. What are your feelings about loaning money to relatives, particularly when they have a history of not repaying loans? --Elaine

Answer: My feelings about lending money to relatives are similar to my feelings about gambling -- generally, you should do it only if you can afford to lose the money. And even then you need to proceed with caution.

That may sound cynical, but I think of it more as realistic. After all, if someone has decent prospects for repaying a loan, they go to a bank or some other financial institution. The fact that a relative is approaching a family member instead suggests that he or she wouldn't qualify for the loan under usual credit standards, hence a greater risk the loan won't be repaid.

And even if you can afford to absorb the loss, lending to relatives still isn't an activity to engage in lightly, as it can complicate family relationships and lead to bruised feelings and resentment all around, whether or not the debt is repaid.

Assuming you've accurately described the behavior of your sister and brother-in-law, it's hard to imagine how you could have reasonably justified giving them a loan. In fact, I'd argue that you didn't turn them down for a loan so much as you declined to become an enabler in their profligate ways.

As for your brother-in-law's threat of not letting you see your sister and nephew, well, it would be a shame for your family and his if he carries through on it.

But aside from maintaining your composure and hoping he comes to his senses, I don't see that there's much you can do about that. It's certainly not a reason to reconsider lending him the money. If anything, his over-the-top reaction shows that you made the right decision in not entrusting this clown with your dough.

That said, there may be times in the future when a similar issue comes up again with other relatives you may feel are more deserving of help. Should that happen, here a few guidelines to follow:

Document the loan. Basically, you want to establish that this is a bona fide loan. This makes it clear to the borrower that he or she is taking on a real financial obligation and that you expect it to be repaid. It also makes it clear to the IRS that you're really lending the money, not giving it away. By doing this, you may be able to claim a non-business bad-debt tax deduction if your relative doesn't pay up.

Although it's possible to draw up your own loan contract specifying the term, payments, interest, etc., it's probably easier and safer to download a promissory note form from an online supplier of legal documents like Nolo.

Or, for $199 plus $9 per payment, you can have Virgin Money create a personal loan agreement and manage the loan, a service that includes transferring payments from the borrower's bank account to yours and reporting those payments (or lack of them) to a credit bureau.

Charge a reasonable rate of interest. You can set a higher loan rate, but you'll want to charge at least the Applicable Federal Rate, or AFR, which is a minimum mandated for tax purposes. If you charge less than this amount, you may have to pay income tax on "imputed interest" -- the difference between any interest income you did receive and what you would have gotten had you charged the AFR.

Depending on the size and type of loan, you could also face gift-tax ramifications. (IRS publication 550 addresses these issues.)

But such matters aside, I think setting a loan rate equal to or higher than the applicable federal rate makes sense because it's another way of signaling that you take this loan seriously, and that you expect the borrower to do so as well.

Consider consulting a pro. There are other messy details that can arise and cause problems when you lend money to family members. For example, if your relative defaults on the loan and you want to claim a bad-debt deduction, you may have to actually first take legal action to show you tried to collect. That could make family get-togethers a bit awkward to say the least.

So if you're thinking of lending a significant sum of money to a relative, you may want to consult an attorney or tax accountant first, just to be sure you know what you're getting into. Indeed, doing this ahead of time may very well reduce your chances of having to consult one under worse circumstances later on.

Talkback: Have you had experiences lending money to family members? Were you paid back? Post your comments below.

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