Loaning money to family or friends fraught with pitfalls

'Mates rates' interest can lead to high emotional cost.

contractIn 2017, a Brisbane court heard the case of a son who refused to repay $280,000 that his parents loaned him to keep his business running, with loans taken from his parents 13 times over four years for both personal and business reasons.

The son said he'd accepted his parent's money as a 'gift' and not as a loan. The parents could not prove they had legally enforceable loan agreements with him. Even though the son had declared in an email that he would pay back the money, it was no more than a moral obligation, not a binding loan agreement. The parents later appealed and the Court of Appeal ordered the son to repay his parents $286,471 with interest. This illustrates often overlooked principles when lending to loved ones. 

Make invisible loans more solid
A 2016 RMIT report research estimates the informal lending market between families and friends worth $1.6 billion a year. CPA Australia found funding from family and friends as a genuine source of small business finance. CommBank Kaching found the average Australian borrowed $200+ from 'someone close to them' nearly every month.

Despite 'loan-gifts' still occurring, very few are documented. Most informal loans are invisible and grossly underprovided for in terms of financial, legal and tax advice.

There are also loan-gifts to purchase property with significant growth in the family guarantee, allowing borrowers with little or no deposit to finance property. In many cases, a borrower's parents provide a limited security guarantee secured against their home, an investment property or a sum – possibly a term deposit.

Loans to family for businesses cause the biggest problems and tend to be handled with little professionalism. Family cannot scrutinise a prospective business as a professional would with profiling risk part of the process.

What can be done? Why documentation is vital
Irrespective of the size or amount of wealth, the principles should be the same by stipulating what's eligible as a loan, clearly outlining the terms of the property or business deal and formally setting out repayments.

A written application setting out the same principles as a loan offered in any ordinary commercial environment stating who reviews and approves it should be documented.

Education is a big part of the equation, including a family-wide policy on the provision of family capital, where "the expectations are clear and an education process occurs in advance of the need".

If you act as guarantor, ensure the amount guaranteed is repayable as there could be repercussions if you offer an unlimited guarantee. There also needs to be a formal conversation among family members to mitigate any future disputes when dealing with family businesses.

What is a loan and what is a gift?
Loans and gifts might feel similar, but they're treated differently in tax and law. A gift is generally not taxable but, in some circumstances, the ATO may treat gifts as taxable income. Importantly, the gift should not have the characteristics of income. Regular payments to a family member or friend, for example, might be construed as income rather than a gift and treated as taxable income, but this is only a guide.

Getting the right documentation in place is the best protection
The specialist team at Collins Hume considers your overall position, not issues in isolation, by bringing together key areas of retirement expertise and wealth planning. 

That way, your whole family has a better chance of maximising wealth, reducing debt, investing for the future and putting all of that to good use for your future and further wealth creation. Call us on 02 6686 3000.

General Advice Warning: This communication has been prepared on a general advice basis only. The information has not been prepared to take into account your specific objectives, needs and financial situation. The information may not be appropriate to your individual needs and you should seek advice from your financial adviser before making any investment decisions. Collins Hume is a Corporate Authorised Representative No. 1243440 of GPS Wealth Ltd AFSL 254544.