The best way to handle this issue is to address it upfront with your client before the loan is made. Is your client willing to write off the balance owed if the child is unable to pay back the loan? While it may not affect your client’s ability to maintain their lifestyle, it does raise the question of whether it could affect his or her ability to then loan money to other children should they need money. Many people wish to leave their estates equally to their children. However, if a loan to one child is written off, that creates an unequal distribution. Does your client want to gift an equal amount to other children to keep things equal? If so, what effect will that have on the balance of their assets?
From a tax perspective, missed payments cannot be deducted unless the loan becomes completely uncollectible. If that becomes the case, the lender may be able to deduct the uncollected portion as a capital loss on their individual income tax return. The loss works much like a capital loss on the sale of an investment. It can be used to offset capital gains, and up to $3,000 of the loss in excess of any capital gains can be deducted against ordinary income tax. Unused losses can be carried forward to future years.
Any discussion with clients about lending money to children can be fraught with emotion. Yet, it’s the financial advisor’s job to understand the baggage that accompanies this issue and point out the pros and cons to help the client stay clear-headed and practical in making any decisions.
Howard Hook is a financial planner with EKS Associates in Princeton, N.J.