In today's tough economy, you may decide to loan money to a cash-strapped family member. While this may be a noble cause, please take my advice and make the loan the tax-smart way. Here's what you need to know.

Charge IRS-Approved Interest Rate

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If you make a loan to a family member and charge zero interest, you may face unfavorable and complicated tax rules (as I'll explain later). But you can avoid tax-law complications if you charge an interest rate that at least equals the IRS-approved applicable federal rate (AFR). Because AFRs are almost unbelievably low right now, you can be nice to yourself by charging the AFR while still being plenty nice to the borrowing family member as well.

Here's what I mean. As this was written, the AFRs for term loans -- which means loans with a defined repayment schedule or a specific balloon payment due date were as follows (based on semi-annual compounding).

• 0.23% for "short-term" loans of up to three years
• 1.07% for "mid-term" loans over three years but not over nine years
• 2.61% for "long-term" loans over nine years.

Wow! AFRs are updated monthly in response to ever-changing bond-market conditions. Today's super-low AFRs reflect the current super-low interest rate environment (which may not last too much longer). AFRs for each month are published in Internal Revenue Bulletins and can be found at www.irs.gov. With a term loan, the AFR on the month you make the loan applies for the entire term.

Tax-Smart Family Loan Strategy in Action

Say you want to lend $50,000 to your adult Sonny Boy so he can buy his first home at great price that seemed inconceivable a few years ago. You could make a nine-year term loan with a balloon repayment at the end and charge the mid-term AFR, currently just 1.07%. Sonny Boy can pay that super-low rate for the entire nine years.

Say you want to make a 15-year term loan instead. No problem. Just charge interest equal to the long-term AFR, currently about 2.61%. Sonny Boy can pay that low rate for the entire 15 years.

On your side of the deal, you must include the interest income on your Form 1040. On Sonny Boy's side of the deal, he can deduct the interest as qualified residence interest as long as you secure the loan with his home (a relatively simple legal procedure). Otherwise, he generally can't deduct the interest.

Here's the thing to avoid: If you make a demand loan (one where you can demand repayment at any time) as opposed to a term loan, the AFR isn't fixed in the month you make the loan. Instead, you must charge a floating AFR based on ever-changing short-term AFRs. So if you believe, as I do, that interest rates will eventually go higher, you'll want to make a term loan if the objective is to offer a great interest rate to the borrowing family member.

Avoid Interest-Free Loans

If you insist on making a totally interest-free loan to a family member, the dreaded below-market interest rules may apply. If they do, you must follow complicated rules to calculate imaginary interest payments from the borrower to you. Then you get to pay real, live income taxes on the imaginary interest. The imaginary interest payments can also trigger imaginary gifts from you to the borrower, which may eat into your valuable federal gift and estate tax exemption. Crazy? Yes. But I didn't make these rules.

For loans under $100,000, there are some exceptions to the below-market loan rules. But the preferable approach is to avoid them entirely by charging an interest rate equal to the AFR. Plus I think it's best to charge some interest on family loans, just to keep the arrangement on a business-like footing. Believe me when I say that keeping things business-like can save a lot of unnecessary grief.

Mind the Details

Last but not least, please put the loan in writing to make sure the IRS (and the borrower too) will respect the deal as a loan rather than a gift. This is easy to accomplish because several online services offer do-it-yourself loan documents for just a few bucks (for instance, check out www.nolo.com). I also advise collecting loan interest payments at least semi-annually and principal payments promptly when due. That shows you're serious about getting your money back -- with interest (albeit at a very favorable rate). Follow these simple precautions, and you can give your family-member borrower some great loan terms while keeping the IRS off your back.