Can I Loan Money to a Friend? Financial Considerations

Lending money to a friend involves navigating financial and personal considerations. What seems like generosity can become complicated without understanding the financial, legal, and tax implications. Both lender and borrower should recognize these complexities. Addressing them from the outset helps protect the relationship and financial well-being.

Establishing a Formal Loan Agreement

Creating a written loan agreement is important when lending money to a friend, as it establishes clarity and protects both parties. This document, sometimes called a promissory note, outlines repayment expectations and serves as legal evidence of the debt. Without it, a personal loan could be misunderstood as a gift, leading to disputes or tax complications.

A loan agreement should specify the principal amount and whether interest will be charged, including the specific interest rate. The Internal Revenue Service (IRS) publishes Applicable Federal Rates (AFRs) monthly, which are minimum interest rates for private loans. Charging at or above the relevant AFR helps ensure the loan is not recharacterized as a gift by the IRS.

The agreement also needs a clear repayment schedule, outlining how and when the loan will be repaid. This can include monthly installments, a lump sum, or specific dates. Provisions for missed payments (default terms) should be included. If the loan is secured by collateral, these assets must be described. Finally, the agreement should include names and contact information for both parties, and both must sign to make it legally binding.

Tax Considerations for Interest Received

Any interest income received on a loan to a friend is generally taxable income for the lender. This income must be reported on your federal income tax return, typically on Schedule B, Form 1040. Even if a Form 1099-INT is not issued, the lender is still responsible for reporting all interest received.

When the interest rate charged is below the Applicable Federal Rate (AFR), the IRS may apply “imputed interest” rules. This means the IRS calculates the hypothetical interest that should have been earned based on the AFR, and the lender may be taxed on this amount, even if not actually received. For example, an interest-free loan could be treated as if the foregone interest was paid and then given back to the borrower as a gift.

If imputed interest exceeds the annual gift tax exclusion, the lender may need to file a gift tax return (Form 709). For 2025, the annual gift tax exclusion is $19,000 per recipient. Gifts exceeding this amount reduce the giver’s lifetime gift and estate tax exemption ($13.99 million per individual for 2025). An exception applies to loans of $10,000 or less, provided the borrower does not use the proceeds for income-producing assets.

Dealing with Unrepaid Loans

If a friend fails to repay a loan, it may be considered a “nonbusiness bad debt” for tax purposes. This classification applies to uncollectible loans made outside of a trade or business. To qualify, it must be a bona fide debt, with a genuine expectation of repayment, not a disguised gift. The debt must also be entirely worthless, with no reasonable expectation of future recovery.

To claim a deduction for a nonbusiness bad debt, the lender must show reasonable collection steps were taken, such as sending demand letters. The deduction is treated as a short-term capital loss on the lender’s tax return, reported on Form 8949 and summarized on Schedule D.

The amount of a nonbusiness bad debt deductible is subject to limitations. It can first offset capital gains. If the capital loss exceeds gains, up to $3,000 of the remaining loss can be deducted against ordinary income annually ($1,500 for married individuals filing separately). Any unused loss can be carried forward.

Documentation, such as the loan agreement and collection records, is needed to substantiate the claim. The deduction must be taken in the year the debt becomes worthless.