What to do as a parent if your child doesn't pay back a loan

When your child stops repaying a loan, you have five realistic choices: rework the payment plan, forgive part or all of the balance as a gift, count the balance against the child's future inheritance, write it off as a bad debt, or collect it the way any lender would. Each choice has a different paper trail, and the one you pick should match what you actually want to happen to the money and to the relationship. A family loan default is common, and you have more control over the outcome than it may feel like right now.

Start with what you already have in writing. If you and your child signed a promissory note, it tells you the balance, the payment schedule, and what counts as a default. If you never wrote anything down, your options narrow, because a court, the IRS, and your other children may all treat the money as a gift unless you can show it was a loan. Our guide to options when any family member stops paying covers the general picture. This article focuses on the decisions that are specific to parents.

Here is the example we will follow. Linda lent her son Marcus $9,000 to replace his car. They signed an interest-free installment promissory note calling for $250 a month for 36 months. Marcus made 12 payments, which is $3,000, and then lost his job. He owes $6,000 and has missed two payments.

Five options and what each one requires

For most parents, the first conversation is about a new payment plan. If Marcus can pay $125 a month while he looks for work, the $6,000 balance would take 48 more months to clear. Put the change in a short signed amendment that names the original note, states the new payment amount and start date, and says every other term stays the same. If you skip the amendment, a missed payment under the new plan becomes an argument about which schedule applied. Our article on renegotiating payment terms includes amendment language.

Forgiveness is the option many parents end up choosing, and it is a gift for tax purposes. The Internal Revenue Service (IRS) defines a gift as any transfer to an individual where full value is not received in return. Gifts that are not more than the annual exclusion for the calendar year are generally not taxable, and the IRS publishes that per-person amount each year. A forgiven $6,000 balance is well below it, so Linda would not need to file a gift tax return unless her other gifts to Marcus that same year push the total over the exclusion. Our guide to forgiving a family loan walks through larger balances, where forgiving part of the debt each year can keep every year under the limit.

If you forgive the loan, put it in writing anyway. A one-page release signed by you, stating the date, the original amount, the remaining balance, and that you release your child from any further payment, closes the note cleanly. Keep it with your estate papers so an executor never tries to collect a debt you already forgave.

When you have other children to think about

Parents with more than one child often care less about the money than about fairness. If Linda has a daughter who never borrowed anything, Linda may want the unpaid $6,000 to come out of Marcus's share of her estate. The simplest way to do that is a clause in her will or trust that names the note and says the unpaid balance at her death is subtracted from his share. Our article on counting a note against an inheritance explains how executors handle that clause.

Do not count on state law to make the adjustment for you. In Florida, for example, a lifetime gift to an heir counts against that heir's share when there is no will only if it was "declared in a contemporaneous writing by the decedent or acknowledged in writing by the heir." A loan that you quietly stop collecting does not meet that test on its own. A signed note helps, and an express clause in your will removes the guesswork.

Writing the loan off on your taxes is possible, but the rules are strict for loans to relatives. The IRS says that to deduct a bad debt, you must show that at the time of the transaction you intended to make a loan and not a gift. It also says that if you lend money to a relative "with the understanding the relative or friend may not repay it," you must treat it as a gift and may not deduct it. A personal loan to your child is a nonbusiness bad debt, which must be totally worthless before you can deduct it, and you report it as a short-term capital loss on Form 8949.

The return must also include a statement describing the debt, the borrower's name and family relationship to you, your collection efforts, and why you decided the debt was worthless. That means you cannot both forgive the loan and deduct it. In Linda's case, a deduction would only fit if Marcus cannot pay anything, she has made reasonable efforts to collect, and she has a signed note showing she always expected repayment.

Collecting from your own child is the last resort, but it is a real option when the amount is large or the child can pay and simply will not. The usual steps are a written demand letter that states the balance and a deadline, followed by a claim in small claims court if the balance fits under your state's limit. Watch the clock, because a claim on an unpaid note has to be filed within your state's limitation period. Our statute of limitations lookup shows the period for each state.

Whatever you choose, decide it on purpose and write it down. A loan that drifts between a debt and a gift for years is the version most likely to cause a fight between siblings later, and the one the IRS is least likely to accept as a loss.

Sources

• IRS, Topic no. 453, Bad debt deduction
• IRS, Frequently asked questions on gift taxes
• Florida Statutes 733.806, Advancement