Okay, you've burned every bank in town and your credit report is a series of repossessions, charge-offs, and collections. No lender will touch you with a ten-foot pole. But blood is thicker than red ink, right? Well, maybe. If you are going to borrow from or lend to a friend or relative, read this first -- doing it right can save your finances and your relationships.

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Put it in Writing
Clearly document that the money is actually a loan, even if there will be no interest charged. Put the payment terms and the collateral (what are you putting up as security?) for the loan in writing. Include what constitutes a breach -- how many days late? And a remedy (late penalty). State what constitutes default (how many missed payments?) and what will be done if this happens (your motor cycle / car / jewelry / poodle will be sold and the proceeds used to repay the loan). This clarifies exactly you agree to pay and under what conditions.

Beware the IRS
You don't need a lawyer to draw up the agreement, but it needs to conform to IRS requirements or your lender could find himself saddled with unexpected gift or income taxes. You can easily satisfy the IRS with a do-it-yourself document, available online, in software, or on office supply stores.

Secure the Note
Your friends or family are more likely to lend to you if you offer some collateral to secure your note. If you borrow money for a home down payment, record a note and lien with your county.

Establish Solvency
In order to prove to the IRS that the loan is not a gift, the lender should write a memo establishing that you, the borrower, were solvent (having the ability to cover your expenses) at the time of the loan. This proves the lender has a reasonable expectation of repayment and is not actually making a gift.

Determine an Interest Rate
Many loans among family members are interest-free. But if you don't set an actual interest rate, the IRS will do it for you and tax the "income" to the lender. The IRS asserts that for a loan to be a loan, interest must be paid, and if interest is being paid, someone owes tax on it.

But it gets worse -- if you don't pay interest, the IRS decides the lender gave you the money to pay the interest, and hits her with gift tax on it. So the money she never received but pays taxes on anyway could also count against the $11,000 annual tax-free gift limit.

Offer a Demand Loan
To minimize potential gift tax problems, designate interest-free money as a "demand loan." This means your lender-in-shining-armor can demand full repayment any time. While this doesn't sound like a good deal for you, realistically, your lender knows full well you can't repay the money in one shot -- that's why you're borrowing in the first place, duh. You can still establish a repayment schedule. If you do not make an interest-free loan a demand loan, the IRS will add up all the interest you would pay for the life of the loan and count it as a gift in the year the loan is made and punish your nice lender for his good deed.

Probably the best way to dodge all these hassles to simply pay interest on the loan. The IRS uses what it calls applicable federal rates, which change monthly, to determine if the interest rate is proper. If the lender charges at least the applicable federal rates, she simply reports the interest payments as taxable income. You can find those rates on the IRS Web site.

Don't Default -- But if You Do...
There are few things that blast apart friendships or family relations like bad debts. That's why an agreement in the case of default can keep things fair and minimize hard feelings. If you don't pay up, and there's no collateral pledged, you can unleash the IRS on yourself and your lender. If your lender tries to write off your bad debt on her tax return, the IRS will come after you for the lost tax revenue. And with no family feelings to get in the way, the government is one tough bill collector.