Financial Advisor

Family Bonds

Clients face both financial and emotional traps when they loan money to family.


October 2009 issue

When Steve Replin’s cousin asked him for a $45,000 loan about seven years ago, he reluctantly acquiesced. Replin says his cousin, who was about 58 at the time, had always been a schemer, trying to make a quick buck, but he was going to put up stock in a small public company as collateral, so Replin figured he was protected. And he obtained a promissory note. Otherwise, the loan could have been perceived as a gift.

“He’s a relative,” says Replin, an entertainment lawyer in Denver. “I thought, ‘Who’s going to let down a relative?’”

Well, Replin’s cousin did let him down. He refused to repay the loan.

“I called him up and said, ‘Hey, Bob. Do you remember me? You owe me money.’ He said, “To hell with it. I’m never going to pay you back.’ And then he said, ‘You can’t sue me. I’m a relative.’”

But Replin did sue. And after nine months of aggravation and attorney’s fees, he received a judgment against his cousin. When he went to sell the collateral, though, it was almost worthless. Fortunately, he found a man willing to pay $45,000 for the shares, given that he already owned a big part of the company anyway.

Replin says he sometimes sees his cousin around Denver, and he acts like nothing happened. A few years later, Replin’s uncle, who owed $450,000 in taxes on various properties, also asked if he could borrow some money. This time Replin declined. If the uncle had defaulted, Replin would have had to foreclose on his properties, which he didn’t want to do.

“He told my father, who got really perturbed,” Replin says. “But he got over it.”

Loans among family members are nothing new. But with the recession in full swing, some advisors say they have seen an uptick in family borrowing as people lose their jobs and find it hard to make payments on loans they took out when times were better.

Rebecca Schreiber, a certified financial planner in Silver Spring, Md., says a lot of her clients are young professionals who have been hit hard by the recession, and she’s seen some of them borrowing money from their siblings. “Younger people are statistically the hardest hit in terms of unemployment, and they’re turning to each other for help instead of to their parents because they are more worried about their parents than their siblings,” Schreiber says. “I’ve been doing this five years, and that’s something I’ve never seen before.”

Schreiber says she has at least one client who receives periodic calls from her siblings, so much so that it’s become part of the client’s financial plan: setting aside money to lend to family members. “For a lot of siblings, it isn’t really lending, it’s giving. It’s a way to keep them in your life,” she says.

Of course, that’s one of the biggest problems with lending to family members. Relatives feel less obligated to pay the money back. The threat of foreclosure or credit being damaged isn’t usually there, and when it’s a parent lending to a child—a relationship in which the money used to flow freely—it’s easy to see the loan as a gift, even if the child has every intention of repaying it. Sometimes children are even surprised when their parents demand repayment.

Andrew Seidenfeld, for instance, was a publicist in the music industry in better times, but his business dried up and now he drives a limousine. Even that business has fallen on hard times, though, and his employer recently cut everyone’s hours significantly. Seidenfeld, 47, says he makes about 30% less than he did last year, making it hard to pay his mortgage. When he mentioned the problem to his father, he was offered a $500 loan, but his father asked to be repaid in three months’ time.

Seidenfeld says he’s already about $1,000 in the red and isn’t likely to be able to pay it back for several more months. He sent his father a printout of his finances from Quicken with the hopes he would understand. “I was hoping he could just give me the money, but he did specify he wanted to be paid back,” Seidenfeld says.

Bruce McClary, a media relations coordinator for ClearPoint Credit Counseling Solutions, based in Richmond, Va., says he’s seen a lot of people lend family members money where everyone had the best of intentions, but it rarely turns out well.

“People put faith before fact, and in a lot of situations, they overlook the details,” he says. “I think people have a big heart, but when they shake hands and say, ‘Pay it back when you can,’ you might as well say forget about paying me back. It becomes a gift.”

McClary says he knows of one young woman who had just started out on her own, had moved out of her parents’ house, obtained a job and was doing fairly well when, in an odd turn of events, her parents approached her for a loan. She wound up opening up a credit card account and giving them access to it, making them authorized users. The parents eventually ran up $5,000 to $7,000 in charges and then told her they were not going to pay her for it.

“Their reasoning was that something she did upset them, something that had nothing to do with her decision to help them,” McClary says. “The end result was that she was stuck with the bill.” It took her four years to dig out of the hole, and her credit was damaged in the process.

Another client of McClary’s was a soldier, deployed to Afghanistan right after September 11, 2001, who had given his parents the power of attorney and oversight of his finances while he was gone, as many in the military do. But when he returned, he found his parents had opened up lines of credit using his name and had borrowed about $12,000, which they never repaid. The son refused to prosecute or even talk to an attorney about the situation.

“It was shocking because they didn’t think twice when they went out and abused their son’s good name,” McClary says. “The family connection makes it difficult when things go bad because you want to believe the best you can in these people who have failed on their commitments, and so enforcement gets tricky.”

Stuart Rohatiner, a tax manager with Gerson, Preston, Robinson & Co., an accounting firm in Miami Beach, Fla., has had to call a few clients on vacation at year’s end to make sure they’ve made interest payments on their interfamily loan, lest it be perceived as a gift. He called one client as he was skiing a black-diamond run in Park City, Utah, and made him go back to the lodge to call his banker to make a payment. There were only a couple of hours left in the year, and the client needed to make an interest payment on the $60,000 loan he received from his mother, otherwise the tax authorities would consider it a gift.

“The IRS looks very closely at loans made between family members,” Rohatiner says. “It wants to make sure that these loans are not disguised gifts. People take related-party loans too casually.”

Some advisors also use loans between family members for estate planning, according to Jeffrey Asher, a partner with Eaton & Van Winkle LLP in New York. For example, a father can transfer his wealth—even temporarily—to his children at an amazingly low interest rate right now, and those children can use the loan proceeds to repay student loans, credit card debt or other liabilities; to fund the down payment on a new home; or to buy a business. The children can even borrow the money and invest the proceeds, earning a profit on the spread between what they pay their parents and what they earn on their investments. The children, of course, have to repay the loan.

Intrafamily loans also can be used to help with Medicaid eligibility. Applicants for the program are often in danger of being disqualified because they own certain nonexempt assets, which they can’t transfer to someone else without a penalty. But the applicant may be able to lend those assets to a family member as long as a promissory note is drawn up and it complies with the rules established in the Deficit Reduction Act of 2005. The federal government is concerned less about the interest rate on the note than about the amount and term of the loan.

“With the right client and in the right hands, an intrafamily loan may be the difference between someone getting Medicaid benefits and not getting them,” Asher says.

Whether for good planning or good parenting, loans to relatives can be pretty risky for many reasons, not the least of which is that money is an emotionally charged topic for a family. It’s a proxy for other things. Parents can use it to show love, generosity or control, and children who accept it may feel beholden, like they lack independence—not the type of feelings they have when they borrow from a bank.