Dear Rick

My sister and her husband have been in serious financial distress due to COVID-19. I want to give my sister money; however, my wife is against it; she thinks we should lend her the money, not give it to her.

In order to promote harmony at home, I decided to lend my sister money rather than give it to her. I have a few questions on this. The first is, if I later forgive my sister’s debt, are there any tax consequences for me or for my sister?

My wife also wants to know what happens if my sister and her husband file for bankruptcy; are we losing money? Be aware that we are planning to loan my sister and her husband $ 50,000, and my wife insists that everything be written down.

Thanks Bret

Dear Bret

First, I agree with your wife that any time you lend money to your family and friends, it is important that the agreement is in writing. You don’t want misunderstandings, which can cause family conflict.

As to whether you and your wife decide to forgo part or all of the loan, there are tax consequences. If you forgive the debt, you are actually giving your sister and her husband a gift. As a result, there are tax consequences on donations.

Under our gift tax laws, it is the person who makes the donation, not the person who receives it, who is responsible for the tax consequences. The annual gift tax exclusion is currently $ 15,000. This means that you can donate to anyone you want $ 15,000 each year without any tax consequences on donations. Plus, a spouse can join the donation, which means husband and wife can donate up to $ 30,000 per year to anyone they choose without tax consequences on donations.

Theoretically, if you choose to give up the entire $ 50,000 and since the debt is in both your sister’s and her husband’s name, between you and your wife, you can give each of them $ 30,000. Therefore, if you forfeit the entire $ 50,000, there will be no tax problem for you due to the annual exclusion. If you later decide to write off the debt, neither your sister nor you will have any unfavorable tax problems.

If your sister and her husband file for bankruptcy, it is more than likely that the loan will be canceled by the court, and you and your wife will not be entitled to any compensation.

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From a tax perspective, it is possible that at that point you can write off the debt as bad debt. This would be your only solution, as the law would prevent you from trying to collect the debt from your sister or her husband.

I know many of you think it is not fair for a person to go bankrupt and have their debt paid off. It may be, but it is what it is. The only way to protect yourself is for the debt to be secured by an asset.

For example, when a person takes out a mortgage, the mortgage is secured by the house. Therefore, if someone declares bankruptcy, they can be released from the obligation to legally pay their mortgage; however, the mortgage company would take possession of the house. Typically, in most situations with family and friends, there is no collateral and therefore the loan is treated as unsecured.

I can’t stress enough how important it is, when loaning money to your family and friends, that you take the deal down in writing and have a conversation to make sure it is clear that you expect to be refunded and what are the refund terms.

I know that sometimes these conversations can be awkward and difficult; However, the last thing you want is conflict within the family. Make sure the deal is in writing and you are having a tough conversation so it is clear that this is a loan, not a gift and you expect the money to be paid back .

Good luck.

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