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If you have relatives or friends that are able and willing to lend you money, and you feel comfortable borrowing from them, doing so can be a good alternative. But always remember to establish a business-like approach. You don't want this transaction to interfere with your personal relationship.

Make sure you take the steps that would be required if you were borrowing from a bank. Draw up an official note which states the following:

• interest rate, if any (see "Below-Market Loans" below);
• how much you are borrowing;
• the term of the loan (when the loan begins and ends); and
• collateral, if any.

Also include any other information that you or the lender believes to be relevant. Failing to do so can lead to problems in the future. There's always the possibility of relationships being tarnished when you borrow money from friends or family.

Is the Interest Tax-Deductible?

Interest paid on the loan is deductible if the loan is used for business or for purchasing investments (up to net investment income). If the loan is used to buy real estate, the interest may be deductible as long as the loan is secured by the real estate and the qualified residence interest rules are met. A secured loan must be recorded with the county where the real estate is located (or other filing place, as state laws determine).

Below-Market Loans

If the interest rate charged on a loan is below the Applicable Federal Rate (for example, a gift loan), which is typically the case between family members and friends who make loans to each other, then the lender may be required to add imputed interest to income. This would result in more income subject to income taxes for you as the lender. For gift loans between individuals, the IRS generally mandates imputed interest income to the lender and imputed interest expense to the borrower. However, gift loans are exempt from the imputed income rules if they meet the following criteria:

1. The gift loan amount is $10,000 or less and the money is not used to purchase income-producing assets, such as stocks,

OR

2. The gift loan is $100,000 or less and the borrower's net investment income each year does not exceed $1,000.

In addition to income tax implications, a gift loan also has gift tax consequences that are not eligible for the above exemptions.

Call your tax professional to clarify the tax treatment of below-market loans.