Dear Rick:
A couple of years ago my son and I talked to you after one of your seminars and you recommended that my son, who was in his early 30s at the time, file for bankruptcy. He took your advice and filed for bankruptcy. It was the best move he’s ever done. He received a discharge from his debts and has become much more fiscally responsible over the last couple of years. For the last year, he has been renting a house. His landlord has recently passed, and the family has offered to sell the house to my son at a substantial discount. The problem is, because of the bankruptcy, my son cannot qualify for a mortgage. The mortgage company he’s dealing with said that if I co-signed the mortgage he would qualify. The interest rate they quoted was in the mid-four percent area. I have no problem co-signing the loan; however, I have a CD that’s coming due and I was thinking of using that money to loan to my son. I was told that since this is a loan between family members, my son would not be able to deduct the interest he pays although I would have to pay tax on the amount I receive. That doesn’t seem fair, and I question if there is anything I can do to allow my son to deduct the interest?
Sid

Dear Sid:
The first thing that is important to understand is that fairness and taxes don’t go hand in hand. As I learned in law school, taxes are not meant to be fair rather they are supposed to raise revenue. Therefore, we should never think that tax laws are meant to be fair.

That being said, the information you received regarding the tax deductibility of interest was wrong. The fact that the loan to your son is made between family members is relatively immaterial. That fact alone would not in and of itself prevent your son from deducting the interest.

It is important to remember that when it comes to individuals, most interest is not tax deductible. For example, the interest that you pay on charge card debt or on your car loan is not tax deductible. The one exception to the rule is mortgage interest which is tax deductible.

The key to making interest tax deductible is not who is loaning the money but rather, is there a security interest (mortgage) on the individual’s personal residence. Therefore, in order to make the debt tax deductible you need to put a mortgage on the property.

Many people are under the mistaken belief that mortgages are only given by banks and other financial institutions; that is not the case. An individual can give another individual a mortgage; all they need to do is complete the necessary legal documents which are relatively straightforward. That being said, I would recommend that you do have an attorney draft the documents so you can make sure that everything is done properly.

The other benefit to having an attorney draw up the documents and having those documents executed by your son is that he will see you’re taking the loan seriously and thus, so should he. Many times I have seen family members loan money to other family members and unless there is some sort of documentation, some people think the loan is actually a gift that doesn’t necessarily need to be repaid. By having your son sign legal documents, he hopefully will take his responsibility of repaying the loan seriously.

One last note and that is don’t forget to issue your son a 1099 at the end of the year. The 1099 documents the interest that he paid throughout the year. This is the document that he would present to his tax person on a year-by-year basis when he has his tax return completed.

Good luck!

If you would like Rick to respond to your questions, please email Rick at rick@bloomassetmanagement.com