It is increasingly common that family members may wish to provide financial assistance to another family member — whether it be lending funds to a child for a house deposit, assisting an elderly family member with accommodation arrangements, or helping a family member undertake a significant investment or business endeavour. Sometimes, there is simply a desire to give money to children as a form of early inheritance so that such parents can witness a child use the money during the donor’s lifetime.
If you are planning to assist or provide funds to a family member, you may be wondering how you should structure this transaction to avoid unintended consequences.
Gift or loan – what’s the difference?
A gift is a transfer of money or property from one person to another for ‘no consideration’ – that is, unconditionally and with the ‘giver’ not receiving anything in return.
A loan is a legal arrangement where a person borrows money from another person, subject to an obligation to repay the loan, and any other terms that are agreed to.
Importantly, a loan is a contract, and if the terms are breached, either party can take legal action to enforce the contract.
A gift is gratuitous, and is not made in exchange for anything else. If a person says they will make a gift to you and then doesn’t follow through, usually there is no recourse because no contract has arisen.
However, once a complete gift is made it is a complete transfer of rights in the subject of the gift – the giver has no right to change their mind or request the gifted property back.
What is a secured loan?
A secured loan is a loan that is secured by an asset. The terms of the loan will provide that if the loan is not repaid, the lender can sell the asset to recover the amount owed to them.
A secured loan also provides an advantage if a borrower goes bankrupt, as secured assets must first be used to repay the secured loans in priority to any unsecured loans.
A mortgage is often used where real estate is used as the security. It is not only banks who can register a mortgage – a family member who lends money can secure their loan against property and register a mortgage to protect their interest in the property.
How do you make a gift or loan?
Loans can be made by agreement or inferred by conduct. The terms of a loan can be made in writing, orally, or in a combination.
A loan made in writing is generally preferred so there are clear terms of the arrangement (and therefore less chance of such terms being disputed).
A gift is made by delivery of the money or property by the giver with an intention to completely dispose of the money or property. While a gift can be documented, the document itself does not cause the gift to take effect, it merely evidences it.
Why is the distinction important?
Disputes can arise where there is a lack of clarity around whether the transaction was intended to be a gift or loan. A miscommunication between a parent and a child about this could cause family disharmony, particularly if a request for repayment is made unexpectedly during financial hardship.
However, disputes often arise in circumstances outside the family members’ control. Whether or not a transaction is a ‘gift’ or ‘loan’ may become significant where:
- a family member goes through a relationship breakdown;
- a family member faces debts, is pursued by creditors or becomes bankrupt;
- a family member dies.
When a dispute arises, courts look at the substance of the transaction to determine the rights of the parties. It is not enough that a transaction is called a loan by one or all parties if it appears to actually be a gift – a court will look at the actual intentions of the parties.
Family members often enter into these arrangements informally and without documentation, and often assume a dispute will not arise.
However, for any significant potential loan or gift transaction it is important to seek legal advice and consider documenting any arrangements.
What terms are required in a loan?
At its simplest, a loan can simply be a transfer of money made with an agreement that the money will be repaid. There is no requirement that a loan accrues interest, has regular repayments, has security, or has an end date on which the loan must be repaid.
However, it is recommended that a loan have clear written terms. The best protection is usually found in loans that have arm’s-length and commercial terms. In order to make a secured loan, the terms must be in writing.
In what case should I make a gift?
A gift is suitable where you are prepared to part with the money or property unconditionally, and you have no concern about any claims that may be made against the gift in the hands of the recipient.
A gift is also suitable when you do not wish to create a legal obligation between you and your family member.
If you are making a gift to a person who may be a beneficiary of your will, you should consider whether the gift should be taken into account in your will as an advance on their inheritance. This must be specifically addressed in your will.
If you are gifting property, you should consider whether there are tax consequences arising from the gift. In the case of real estate, capital gains tax and land transfer duty often apply to gifts made during life (and these may be avoided by making a gift in a will).
In what case should I make a loan?
Loans are often preferable to gifts for asset protection reasons.
For example, if a parent makes a gift of $1 million to a child to purchase a house, and that child later divorces, the house may form part of the asset pool in a family property settlement. If the parent instead loaned $1million, then the outstanding loan amount would have to be repaid to the parent (for example, from the sale proceeds of the house) and would not form part of the asset pool.
Considerations and risks when making loans
- Proof: The first major issue that arises is determining whether a transaction is a loan or a gift. Having clear documentation of the transaction at the time it is entered into (rather than after the fact) is essential.
- Terms: The terms of a loan should be clearly documented and contained in a signed agreement. It is preferable that all terms are in writing.
- Interest and repayments: A loan should usually require payments of interest and principal to be made. An interest-free loan may suggest that the transaction is actually intended to be a gift.
- Security: Where the loan is for a significant amount, or where the lender is concerned to protect their financial interests, a secured loan provides much greater protection to the lender. A registered security, such as a mortgage, is best practice.
- Compliance: In many family loan situations, it is common that the terms of loan agreements are not enforced, and compliance with the loan terms falls away. While it may be awkward to raise a late payment or default with a family member, a lack of compliance can suggest that the loan is not intended to be repaid or has been forgiven. It can also raise legal issues, such as limitation periods (discussed below). This can expose the funds to claims from outside parties.
- Evidence: It is also important that records are kept of advances, repayments and interest. It is preferable that regular statements are kept and provided to the parties to the loan.
- Income: It must be remembered that interest earned on money loaned to a family member is taxable income, and will need to be reported.
The importance of actual repayment
Loans (and all other contracts) are subject to ‘limitation periods’. A limitation period is a time limit set by statute which prevents a person from suing under a contract after a period of non-action. For loans and contracts, the limitation period is 6 years in most states and territories.
The limitation period will commence from the time that a demand can be made for repayment of the loan amount – for example, upon the end of the loan term, or after the borrower defaults on a repayment. The time limit can be ‘reset’ by:
- a payment being made; or
- an acknowledgement of the loan by the borrower.
Some loans are made ‘repayable on demand’, or without any clear terms as to when they may be repaid. The limitation period for these loans can start immediately from the loan being made – therefore, if no payment is made within 6 years of the first advance, the loans could become entirely unenforceable by the lender unless other steps are taken.
You should seek specific advice in relation to the applicability of any limitation period to your circumstances.
Wills and estate planning
It is important to consider the effect of a gift or a loan on your estate planning, particularly where the gift or loan is made to someone who may benefit from your estate (such as a child or grandchild).
Where you have made a gift to a family member, ordinarily that gift is not taken into account in the distribution of your estate. If you intend for a gift to be taken into account as part of an inheritance, your will must clearly state this.
On your death, any loan you have made becomes an asset of your estate. The executor of your will may be able to enforce the loan, or transfer the loan to a beneficiary of your estate.
You may choose to forgive a loan in your will. However, it is important to note that your executor may not be able to forgive a loan unless there are specific instructions and powers in the will – and your executor may have a legal obligation to recover any outstanding loan as part of the administration of your estate.
Where a loan has been made to a beneficiary, your executor is generally entitled to deduct the loan amount against their entitlement. This applies even in respect of loans that have expired because of a limitation period.
It is important to clearly document in your will whether you intend to forgive any loans, and whether you wish to have any loans or gifts taken into account in the distribution of your estate.
Social security and aged care concerns
Making a gift or loan can impact your age pension, or the fees you pay when entering aged care.
Under the pension income and assets test and the aged care means test, any gift of more than $10,000 in any year, or of over $30,000 across five years, can be treated as a ‘deemed’ asset for up to five years after the gift is made. This means that the amount you have gifted in excess of the limits will be assessed as your asset, even if the funds are no longer accessible to you. This can mean your pension is reduced for up to five years from the time of the gift.
Planning to provide financial assistance to a family member?
For advice tailored to your specific situation, don’t hesitate to reach out to our team at Hamilton Locke Private. Contact us today to ensure your financial decisions are informed and secure.
