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Our daughter Meredith, a college junior, hasn't asked to borrow money from us -- yet. She probably will someday, to help buy a house, to pay off debts or maybe even to start a business. And one day you too may be asked for a loan by your child or another relative.

Before you agree, however, ask yourself: Can you afford to part with the money? And do you stand a reasonable chance of getting it back? If you answer no to either one, don't lend the money, no matter how much you would like to help.

Even if your answers are yesses, don't rush into a loan. First consider making the money a gift. You can give as many people as you wish up to $10,000 a year each without triggering federal gift taxes. (You never actually pay gift taxes; they come out of your estate.) This means that every year, you and your spouse can each give two children -- or a child and his or her spouse -- a total of $40,000.

It's always wise to spell out the terms of your gift in writing. For instance, if you hand $10,000 to your daughter for the down payment on a house, write a letter saying that the money is a gift and get a thank-you note back. Then, by documenting that the money needn't be repaid, she may qualify for a bigger mortgage. If you'd rather lend the money and it's less than $10,000, the Internal Revenue Service's rules are simple. You can charge as much or as little interest as you wish -- even no interest -- as long as your written agreement notes the date by which the money must be repaid.

For larger loans, the IRS expects you to charge at least what is known as the applicable federal rate and to pay taxes on the interest you receive. The annual applicable federal rate is now 3.96 percent for loans shorter than three years, 5.88 percent for loans of three to nine years and 6.95 percent for longer loans. The Wall Street Journal publishes the current federal rates around the 20th of each month.

What if you want to make an interest-free loan? That's possible. However, if you lend more than $10,000 but less than $100,000, you must generally report as taxable income on your 1040 the foregone interest or an amount equal to the recipient's investment income, whichever is less. For example, if you're making a $25,000, four-year no-interest loan to your daughter and she has $1,500 of investment income, you must pay taxes on the $1,470 in foregone interest ($25,000 times 5.88 percent). If your daughter has investment income of $1,000 or less, however, you don't need to declare any interest because the loan is for less than $100,000.

When you draw up a family-loan document, be sure it includes the amount you're lending, the interest rate (if any), the date by which the loan must be repaid and a description of the collateral. The IRS doesn't actually demand collateral, but we would -- even from our own daughter -- to make sure everyone involved takes the loan seriously. Have your lawyer review the loan document to be sure it adheres to your state's laws.

Without the documentation, the IRS might treat the entire loan transaction as a gift, and your estate could be socked with a bundle in extra taxes -- $9,250 on that $25,000 loan at the lowest death-tax rate of 37 percent.

With a loan in place, you could let your daughter skip her regularly scheduled payments of interest and principal now and again. You won't owe gift taxes on the amount forgiven, as long as the annual total stays below $10,000. Put all this in writing too. That way, you'll prevent anyone -- a disgruntled heir, for example -- from trying to collect the unpaid debt after your death.

Ken and Daria Dolan write the monthly newsletter "Straight Talk on Your Money" ($39.50 a year; (800) 777-2002), and serve as hosts of a daily national personal finance show on the WOR Radio Network.

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