Tax Issue for Private Lending/Investing

[Carmen Marron]

Hi Everyone,

I'm new to this forum so I apologize if I chose the wrong forum for this post but I hope it is correct. I have a situation with some of my clients and I am trying to determine the best way to handle their situation. Here is the scenario (I'll use names so it's easier to identify the people):

1. John tells his buddy Bob that he found a great opportunity to purchase some property low and be able to turn a profit in a couple of months.

2. John asks Bob to lend him $100K and anticipates he'll pay him back $150K after flipping the property.

3. Bob tells his friends and family about the opportunity and asks them if they want in on it.

4. Bob gets $10K from 5 friends and family members and takes $50K out of his personal account.

5. Bob gives John $100K to make his investment.

6. John invests the $100K in the property. He flips it and has $150K he can give back to Bob.

7. John asks Bob if he wants his money back or if he would like to "roll" the $150K into another deal he just found.

8. Bob likes the idea of rolling the money over and so do all his family and friends so they agree to do this.

OK... let's stop here. :) Let's say all of the above happened in 2013 and the money was never paid to anyone - Bob or his family and friends because they decided to roll it into a new deal.

At this point - Bob and all his family and friends still have their money out there. Would they need to report the $50K as "Interest Income"?

Being Bob's friends and family and really lending Bob the money so he can make an investment, would they need to report anything on their taxes? I see it as they have made a loan that has not been paid back yet. Is this accurate? Bob can tell them they've made $5K each but because this wasn't actually paid to them they would not have to report it yet, right? IF Bob actually gave each person $15K back after the first deal, then would each person have to report $5K of income? Being this is money loaned by friends and family there are no formal agreements. I am trying to determine when the people lending the money would have to report income if they do at all.

I'm also trying to determine how Bob would handle these personal loans. If he tracks each deal would he give them statements showing how much they made on each deal? If money is never taken out but continues to just "roll over" then the person who lent the money would not have to report anything, right? Only when they decide to not rollover and get paid in full do they have to report anything, right?

Sorry for the very long post. I'm just trying to wrap my head around this issue being it is not a formal investment.

THANKS! Carmen

[Jon Holdman]

Bob and his five friends are creating a partnership. No paperwork is requried. Just by doing what you describe, its done. You say its "not a formal investment". It is.

At the end of the year, the partnership must file a partnership return. Each of the six members gets a K-1.

I would highly, highly recommend getting a CPA to help you with the accounting here.

If the partnership actually earned $50K in interest income, the K-1s would show $25K in income for Bob and $5K each for the remaining five partners. Whether or not the partnership distributed any money to any of the partners is irrelevant. The income was earned and taxes are due.

The piece I'm not sure about is that if John doesn't make any payments to the partnership is there income. I'll see if @Steven Hamilton II has a minute to answer, but its tax season. The best source of a firm answer is your own CPA or EA. Could be that the partnership has no income for that year because nothing was paid out. Or, it could be the interest was paid, then reinvested. I'm not sure. I have a friend and he and I are both invested in the same local fund. I get the interest on my investment each month while he lets his remain in the fund. We received K-1's just this Wednesday, so I'll ask what shows up on his.

If I were one of the partners, I would want to be very clear with John that the amount of money being loaned is now $150K and that I expect interest on the full amount, not just the original $100K.

Doing this "no formal agreements" is the height of insanity. What if one of the partners dies? Or is sued? Or needs money quickly? You need two sets of documents. One forming the partnership. I would formalize this by creating an LLC, and having a detailed operating agreement that covers all possibilities. When I've done this, its been pages and pages long. You will be surprised what issues can crop up when you start writing stuff down. And then there should be a second set of documentation for the loan from the partnership to John. That should include, at the least, a promissory note and a security instrument (deed of trust or mortgage.)

If you're Bob and you in any way recruited these friends to invest in this partnership you are extremely exposed. This partnership was created and people invested into it (i.e., purchased securities) without doing any of the proper paperwork or SEC or state filings. That may work if its two buddies who decide to create a company and put them money together to do it. If Bob actively recruited these other investors ("hey Joe, I have a way for you to make some money...") then Bob is "selling securities" and is subject to a plethora of regulations. Recruiting small investors at $10,000 a pop with no paperwork is really dangerous. Doing the proper paperwork is likely to be too costly for only raising $50,000. If something like this is what happened, I would strongly recommend you get the money and interest back from John, distribute it to the partners, wrap up the taxes and be done with this. Get out before the lawsuits start. If anything goes south, or John loses the money, its Bob who's going to get sued by these investors.