Where can you get the best terms on a new loan? Frequently, it is the family bank, meaning Mom and Dad, your successful big brother or your great aunt Doris. You may be able to typically get away with a low interest rate, or possibly no interest at all. Trouble is, loans among family members touch on two regions about which the IRS is particularly sensitive: gifts and interest earning. To avoid a tax nightmare afterward, make sure to follow these rules.

Document the Loan

The 1st step to keeping away from trouble is to obviously document that the money is really a loan, with or without interest. The documentation should also include payment terms and the collateral for the loan, if any. This will avoid clash about what exactly you agreed to pay. And, if you do not do this, your lender could find himself paying earning taxes on interest he never received and gift taxes on money he never gave away. And, in the lasting, the loan could cut into the lender’s gift and estate tax exemptions.

You do not need a lawyer to draw up the documentation. In fact, you may be able to easily satisfy the IRS with a do it yourself document. Attempt the document creation software Quicken Family Lawyer, which sells for about $29. It is simple and well worth the price, if you use it only once.

Secure the Note

If you’re borrowing money to purchase a new home, you may want to take the extra step of legally securing the note with your residence. This does require a lawyer. That way you may be able to take benefit of one of the most Liked Tax deductions: interest on a home mortgage. Anybody thinking of not reporting a family loan when applying for a mortgage should think about this point: You could face criminal charges if you falsify a mortgage application to hide the origin of your downpayment money.

Establish Solvency

In order to clarify that the loan isn’t a gift, the lender should write a memo establishing that you, the borrower, were solvent at the time of the loan. This proves the lender has a reasonable expectation of repayment and isn’t really making a gift.

Set an Interest Rate

Interest Free does not mean hassle free. Many loans among family members are interest free. But be cautious. If you do not set an interest rate, the IRS, in its family friendly way, will do it for you. And since that interest could be considered earning for the lender, the IRS will happily tax the interest payments that were never paid. You have now entered the hideously complex world of “imputed interest.” generally, the IRS, keen to increase profit, Decided That for a loan to be a loan, interest must be paid, and if interest is being paid, someone is making taxable earning.

The IRS’s enthusiasm doesn’t stop there. Not only does the agency place a tax on imaginary earning, but it assumes that the borrower couldn’t pay for to make the interest payments he had to borrow money, did not he? , then acts as though the lender gave him the money to pay the interest. Enter the gift tax. So the money the lender never received but pays taxes on anyway could also count against the $11,000 yearly tax free gift bound, and if it exceeds that, then the gift and estate tax exemptions. This isn’t all as bad as it sounds, and usually these penalties may be evaded with good planning.

Avoid Imputed Interest

First, imputed interest and all the crazy imputed earning and gift tax problems usually don’t apply when a loan totals no more than $10,000. But, watch out for this: The $10,000 bound applies to all remaining loans between you and the lender, as well as those charging interest. But if the $10,000 rule doesn’t help, you may be able to turn to the $100,000 rule.

The $100,000 rule applies when the aggregate balance of all remaining loans interest free or otherwise between you and the lender is $100,000 or less. For earning tax reasons, the total of imputed interest is zero if the borrower’s net investment earning for the year is no more than $1,000. Net investment earning, which will include interest, dividends and certain royalties, but not essentially capital gains, is the figure used to find out how much margin account interest may be subtracted on Schedule A. Since majority of people who borrow money from family members are most likely not sitting on big investment portfolios, imputed interest can usually be evaded.

Under the $100,000 rule, when the borrower’s net investment earning exceeds $1,000, imputed interest is restricted to the real total of investment earning. Here is an example: If a mother lends her daughter $100,000 interest free but the IRS sets an interest rate of five , then the mother could have to declare imputed interest payments of $5,000. But if the daughter’s investment earning is less than $1,000, the imputed interest could be zero. If the daughter earned $1,500 in interest earning, the mother could have to pay taxes on only $1,500 rather than $5,000.

To meet the criteria for the $100,000 rule, the lender must gather an yearly declaration that discloses the borrower’s net investment earning.

Demand a Demand Loan

So far, so good. Unfortunately, the $100,000 rule gets really difficult when it comes to the gift tax. The net investment earning rule doesn’t apply here. To minimize gift tax problems, designate the interest free advance as a “demand loan.” that means the lender can demand full repayment at anytime. While this may seem unduly threatening, it may save your lender money due to way the IRS calculates the imputed gift. You may be able to still informally agree on a repayment schedule. With a demand loan, the total of the imputed gift is calculated on a yearly base and will total less than $11,000 a year, so the imputed gift for yearly the loan is remaining will fall harmlessly below the $11,000 yearly bound for tax free gifts.

But if you don’t designate the loan a demand loan, the IRS will add up all the interest you could pay for the life of the loan and count it as a gift in the year the loan is made. The result may be a comparatively big imputed gift that exceeds the $11,000 yearly tax free bound, and also cuts into the lender’s gift and estate tax exemptions.

These rules can get difficult, though, so it’s most likely a smart idea to consult a tax pro before drawing up this kind of loan. The IRS will let you avoid all these hassles if you simply charge interest on the loan. The IRS uses what it calls related federal rates, which change monthly, to find out if the interest rate is correct. If the lender charges at least the related federal rates, he simply reports the interest payments as taxable earning. You may be able to find those rates on the IRS website.

What if You Default

There are not many things that hurt family relations more than bad debts. But the IRS isn’t ashamed to get involved. If your lender tries to write off your bad debt on his tax return, the IRS will try to gather the lost tax from you. Think it will not happen? Well, a 1995 U.S. Tax Court case tells the story of a father who made thousands of dollars in undocumented loans to his 23 year old daughter, who wanted to open a roller skating rink.

The skating rink sooner or later failed, and the father claimed a $35,000 nonbusiness bad debt deduction, though no formal collection efforts were undertaken against his daughter. She had filed for bankruptcy four months earlier. The Tax Court finished that the advances were loans because of “loan” notations the father had made on many of the checks, and because he had earlier made undocumented loans to family members and friends and had been repaid.

So the IRS’s collection efforts against the daughter were accepted.

More from Smart Money:

•, Help! I am Drowning in Debt

•, Debt and your Taxes

•, Bankruptcy: When you are Out of Options