Why Documentation Is Important

Many people mistakenly assume that it is offensive or inappropriate to ask for formal documentation when arranging to transfer funds between relatives or friends. In fact, formal documentation is perhaps one of the best things you can do for your relationship. Not only does it protect both parties financially, it preserves the personal relationship by preventing confusion over repayment start dates, interest rates, repayment schedules, and grace periods.

Accurate records—the promissory note and a year-end report of repayment history—can be used in three important ways:

• To prove that a loan is truly a loan, and not a gift. This is especially important for tax purposes. If a transfer of money greater than $10,000 is indeed a loan, documents and records must be available to prove that to the IRS. This can also be important paperwork if the lender has passed away, and the heirs are trying to resolve the estate.

• To resolve disagreements. If there is any question about whether or not a payment was made, or a disagreement regarding the payoff balance, having a record of the payment history can easily resolve disputes.

• To deduct a loss. If the borrower defaults on the loan and the lender wants to deduct a loss on his or her taxes, the IRS will require proof that that the money lost was in fact a loan, and that the lender tried to collect the missing payments.