By Vera Wilson

Your brother lost his job and his wife is eight months pregnant, so he asks you for a short-term loan to tide him over. Or maybe your best friend wants to borrow some money to launch that decorating business she's been dreaming about for years. You have the funds, but when - if ever - should you loan money to family or friends?   

Your money - or your relationship?

Shakespeare said it best: “Neither a borrower nor a lender be; for oft loan loses both itself and friend.” Late payments or a loan that's never fully paid back can strain or even destroy a relationship. You might feel it's impossible to say no if you want to preserve the relationship. But don't let them take advantage of your good nature. If you fear mixing business with pleasure will prove destructive, then say so. Offer alternative support, such as giving a smaller amount of money as a gift or offering to drive your friend to work until he can afford that new car.   

As good as gone

Never loan money you can't afford to lose. A CNN Money survey suggested over a quarter of loans made to family and friends were never paid back and less than half were paid back in full. Ask yourself: “If the money isn't repaid, what will that do to my financial position?” Like any creditor, you may pursue collection activities like suing the borrower or placing a judgment or property lien against him to recoup the money. That might mean dragging your own cousin to small claims court - something many relatives aren't willing to do.  

Consider the circumstances

It's smart to ask the borrower why they need the money. Emergencies arise, and you might be providing your loved one with the lifeline they need to save their house or cover skyrocketing medical bills. But what if they're just lived beyond their means and want to borrow from you to pay off other mounting debt? Has the bank turned them down because of bad credit risk? If so, maybe you should to turn them down, too. 

Mortgages merit a special mention. They represent the most common intra-family loans, as adult children, excited to buy their first home, might not have enough credit history to satisfy a traditional lender. In turn, a loan can prove profitable for parents because the interest earned is likely to be more than with conventional financial instruments like bonds and CDs, making it a win-win. Using a service like National Family Mortgage, which helps structure the loan and handle all the paperwork and reporting, keeps the process simple and professional.  

A handshake is not enough

If you've decided to make the loan, shake on it, but then insist on putting the loan agreement in writing. This prevents any misunderstandings and protects your legal and tax standing. This promissory note should state the type of loan (secured or unsecured), interest rate, payment amounts and schedule, as well as any penalties and collateral, if applicable. It should be signed and notarized by both parties. Loan-agreement templates are available on websites like www.nolo.com, or consult your attorney.   

Burden of proof

The Internal Revenue Service (IRS) treats loans very differently from monetary gifts. A loan without interest or never paid back might be considered a gift, which can lead to negative tax implications for the lender. To avoid this possibility, charge interest equal to or greater than the applicable federal rate, which is published monthly on the IRS.gov. Current rates range from 0.65 percent for short-term loans to 3 percent for long-term loans. Loan amounts affect the rate as well.

Also, documenting the loan and your attempts to collect it are crucial if you want to claim a bad debt on your tax return and avoid having the money categorized as a gift, in which case you could pay taxes on anything over the current $14,000 exclusion.

If all goes smoothly with the loan, the borrower will need to report all interest paid to you annually on Form 1099, which you'll need to claim as interest income on your tax return.  

Offering money, not advice or a free pass

Friends and family who have successful loan arrangements make communication a priority. Encourage the borrower to let you know if they'll be late or can't pay and consider a more lenient payment plan to keep the loan on track. Lenders also should realize loaning money doesn't give them the right to micromanage the borrower's finances; resist the urge to question their spending habits or offer unsolicited financial advice.