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Retirees, or people on the verge of retirement, have seen their retirement savings dwindle during the recent economic downturn. Many people are no longer in a position to bolster the incomes of adult children with cash gifts, or to bail out close friends in the event of a financial crisis. If loans, rather than outright gifts, now are the order of the day, parents and their children should take time upfront to address some basic issues. Disputes regarding loans have ruined many relationships -family and friends- ever since coinage first appeared. You know that lending money to a friend or relative could rupture a friendship for months, years and sometimes forever, but did you know that ill-conceived loans can cause tax headaches for both the giver and the recipient?

Here are some guidelines to help you and your heirs avoid misunderstandings and potential tax pitfalls:

• First, make is absolutely clear whether the money is a gift or a loan. The way to do this is to put everything in writing including the timeframe and terms for repayment.
• The loan paperwork will help you to avoid running afoul of the Internal Revenue Service (IRS). To prevent the IRS from dealing with the loan as a gift, it is wise to charge minimal interest (currently the minimum rate of interest recognized by the IRS is 0.8 percent a year for loans spanning three years or less). When determining an appropriate rate of interest, bear in mind that the IRS regards any interest you receive as taxable income. If the terms of the loan are scrutinized by the IRS, the inspectors will be looking for evidence that the borrower had a realistic chance of repaying you, and that you were ready to collect in the event of default.
• The IRS allows you to lend a child a total amount of less than $10,000 without charging interest, under the provisions of the current gift tax exclusion. Clarifying the terms of loans in writing under these circumstances will help protect your relationship with your offspring, rather than your tax situation. It’s worth doing nevertheless.
• To protect yourself and your heirs, substantial loans to family members, or loans over long periods of time, should be reviewed by your tax professional and by your lawyer. There might be gift tax or estate tax issues to consider, and your will and estate plan may need to be revised to address circumstances that might arise should you die before the loans are repaid.
• If you wish to convert the loan to a gift over a certain time period, you can do so using the gift tax exclusion mentioned above. Each taxpayer is allowed to give a friend or family member up to $13,000 without gift tax consequences. If you are considering doing this on a wide scale, discuss your plan with your professional tax advisor and your lawyer to make sure you don’t create unforeseen tax liabilities in the future.
• Likewise, if you want to put provisions in your will to wipe out debts owed by your heirs, consult your tax and legal advisors first. This way you can ensure that your generosity does not turn a tax-free inheritance into taxable income for your children.

As with most tax issues, time spent on upfront planning can offset future problems. Prevention is always better than cure.