What The IRS Cares About
The tax issue that comes up most often for private borrowers and lenders has to do with gift tax regulations. According to the IRS, individuals may gift up to $12,000 per person, per year without tax consequences. This means that you can receive up to $24,000 (gifts from two individuals) each year from your parents, and, if you have a spouse, $48,000 (one gift from each parent to you and your spouse.)
However if the money is a loan and is over $10,000, it should be properly documented because it may come under special scrutiny by the tax man. The IRS assumes that transactions between relatives are intended to be a gift, so the burden is on the individuals to provide evidence proving otherwise. To prove that your loan is truly a loan, you will need it to be documented with a promissory note, and should consider paying at least the Applicable Federal Rate (AFR) in interest.
If the interest rate you choose is less than the AFR, or zero, the IRS will view the lender's forgone interest (called imputed interest) as a gift to the borrower. That shouldn't be a problem unless the amount exceeds the annual gift tax exemption of $12,000 per individual (and a lifetime limit of about $1 million). If that occurs, the lender may be assessed a gift tax. If you have concerns about gift tax implications of your loan, please contact an accountant or financial advisor.
Lenders must pay tax on interest income on private loans.
Finally, private loans that default are able to be deducted by the lender as a capital gains loss for the unpaid portion of the loan. However there must be evidence - such as a promissory note, payments, and/or failed attempts at collection - that the lender expected repayment on the loan and attempted to collect on it.
The bad debt is deductible in the year it is determined to be uncollectible. This would generally be the year that collection efforts failed. Since the amount written off is considered to be a short term capital loss it is limited to $3,000 in deduction each year. Like all capital gains and losses there is first a netting to arrive at a net capital gain. If the individual has short term gains it thus would be offset by this loss.
Please note: The material presented above is information, not advice. For financial or legal advice, and for the rules and regulations that apply to your situation, please contact your attorney or accountant.