Family loans allow you to help relatives with better terms than commercial lenders while creating estate planning opportunities. However, the IRS requires specific documentation—including a written agreement, repayment schedule, and interest charged at the Applicable Federal Rate (AFR). Without proper structure, the IRS may reclassify your loan as a taxable gift, triggering gift tax filing requirements and potentially reducing your estate tax exemption.
Understanding IRS Family Loan Requirements
The IRS scrutinizes loans between family members to prevent tax avoidance through disguised gifts. According to the Internal Revenue Service, legitimate intrafamily loans must meet three core requirements: a signed written agreement, a fixed repayment schedule, and interest charged at or above the AFR.
These requirements exist because the IRS wants to distinguish between genuine loans and gifts masquerading as loans. Without proper documentation, even with the best intentions, your loan could be recharacterized as a gift during an audit or when filing your estate tax return.
Written Loan Agreement
A comprehensive written agreement should specify the principal amount, interest rate, repayment term, and payment frequency. The agreement functions as evidence that both parties intended to create a debtor-creditor relationship rather than make a gift.
While not legally required, having separate legal representation for both the lender and borrower strengthens the loan's legitimacy, particularly for larger amounts. This becomes especially valuable if the IRS questions the transaction's authenticity during estate settlement.
The agreement should also address what happens if the borrower experiences financial hardship. Can payments be temporarily suspended? Will late payments trigger penalties? These details demonstrate the loan's business-like nature to the IRS.
Applicable Federal Rate: What Interest Rate to Charge
The IRS publishes Applicable Federal Rates monthly, setting minimum interest rates for family loans based on the loan term. For December 2025, according to Revenue Ruling 2025-24, the AFR rates are:
- Short-term loans (0-3 years): 3.66% (annual compounding)
- Mid-term loans (3-9 years): 3.79% (annual compounding)
- Long-term loans (9+ years): 4.55% (annual compounding)
Failing to charge at least the AFR creates "imputed interest"—the difference between the AFR and what you actually charged. The IRS treats this imputed interest as a gift from lender to borrower, potentially triggering gift tax consequences.
Calculating Interest Requirements
Consider a $200,000 family loan for 10 years. Using the December 2025 long-term AFR of 4.55%:
- Required annual interest: $9,100
- Total interest over 10 years: $91,000
- If you charge 0% instead, that $91,000 becomes a taxable gift
The lender must report all interest received as taxable income on their return. The borrower can only deduct interest if the loan finances their business or qualifies as mortgage interest on their primary residence.
The $10,000 Exception
The IRS provides relief for small loans under $10,000 when the borrower doesn't use proceeds to purchase income-producing assets. These loans can be interest-free without gift tax implications, making them ideal for helping family members with short-term cash flow needs.
Family Loans vs. Gifts: Tax Implications Compared
| Factor | Family Loan | Outright Gift |
|---|---|---|
| Annual limit before reporting | No limit (with proper AFR) | $19,000 per recipient (2025) |
| Lifetime exemption impact | None (if structured properly) | Reduces $13.99M lifetime exemption |
| Income tax for lender | Interest is taxable income | No income tax |
| Deduction for borrower | Only if business/mortgage use | None |
| Estate inclusion | Outstanding principal at death | Not included in estate |
| Step-up basis | Borrower has cost basis | Heir receives step-up basis |
| Repayment obligation | Legal obligation to repay | No obligation |
| Relationship impact | Can create tension over payments | Often cleaner emotionally |
Annual Limit Before Reporting
Lifetime Exemption Impact
Income Tax for Lender
Deduction for Borrower
Estate Inclusion
Step-Up Basis
Repayment Obligation
Relationship Impact
Maximizing Wealth Transfer Through Intrafamily Loans
Intrafamily loans create wealth transfer opportunities when the borrower invests the funds at a rate exceeding the AFR. The spread between investment returns and loan interest effectively transfers wealth to the next generation without gift tax consequences.
Example: Leveraging Low AFR Rates
A parent lends their child $500,000 at the current AFR of 4.55% for investment in a diversified portfolio. If the portfolio returns 8% annually:
- Child's annual investment return: $40,000
- Annual interest paid to parent: $22,750
- Net benefit to child: $17,250 annually
- Over 10 years: $172,500 wealth transfer
This strategy becomes powerful when combined with estate planning. The parent receives steady interest income while removing the principal from their taxable estate as the borrower makes payments.
Intentionally Defective Grantor Trusts (IDGTs)
Advanced estate planners often combine intrafamily loans with IDGTs to amplify wealth transfer. The parent loans money to an IDGT, which invests the proceeds. The trust pays interest to the parent, while investment growth above the AFR escapes estate taxation. This technique works for high-net-worth families approaching estate tax exemption limits.
Required Documentation for IRS-Compliant Family Loans
Beyond the written agreement, maintaining proper documentation throughout the loan's life protects both parties from IRS reclassification.
Essential Loan Documentation Checklist
Consider documenting the business purpose if applicable. A loan for a down payment on an investment property or to start a business demonstrates legitimate economic substance beyond family assistance.
The lender should issue Form 1098 (Mortgage Interest Statement) when the loan exceeds $600 in annual interest and uses real estate as security. This creates additional IRS documentation supporting the loan's legitimacy.
Tax Reporting Requirements for Lenders and Borrowers
The lender must report all interest received on Schedule B of their Form 1040. This applies even when the interest rate barely exceeds the AFR—the IRS expects consistent reporting.
Borrowers can deduct interest only in specific circumstances. Mortgage interest on a primary or secondary residence qualifies for the mortgage interest deduction if the loan is secured by the property. Business loan interest is fully deductible against business income.
Non-Deductible Interest
Personal use loans—including debt consolidation, vehicle purchases, or general living expenses—generate non-deductible interest for the borrower. The lender still reports this interest as taxable income, creating a potential mismatch that family members should understand upfront.
Estate Planning Considerations: Step-Up Basis vs. Loan Spread
Intrafamily loans require careful analysis of step-up basis implications. When a parent holds investments and bequeaths them at death, heirs receive a step-up in cost basis to fair market value, potentially eliminating capital gains tax.
Comparing Approaches
Scenario A - Intrafamily Loan
- Parent lends child $300,000 at 4.55% AFR
- Child invests and grows assets to $500,000 over 10 years
- Child owes capital gains tax on $200,000 gain when selling
Scenario B - Bequest
- Parent keeps $300,000, invests, grows to $500,000
- Parent dies, child inherits with step-up basis to $500,000
- Child pays zero capital gains tax when selling
However, the loan strategy provides liquidity to the child now rather than forcing them to wait for inheritance. The optimal approach depends on your family's timeline, the borrower's investment skill, current AFR rates, and estate tax exposure.
Families approaching the $13.99 million estate tax exemption may prioritize removing assets from the estate through loans, even accepting some capital gains consequences for the borrower.
Common Pitfalls: When Family Loans Become Taxable Gifts
The IRS frequently recharacterizes family loans as gifts during estate audits. Common triggers include:
No Payment History
Loans where the borrower never makes payments signal a disguised gift. Even temporary payment suspensions should be documented with formal forbearance agreements.
Below-Market Interest Rates
Imputed Interest Example
Charging interest below the AFR creates imputed interest treated as a gift. For a $200,000 loan, charging 2% instead of the 4.55% AFR generates approximately $5,100 in annual imputed gifts.
Informal Documentation
Verbal agreements or casual written notes rarely survive IRS scrutiny. The absence of professional legal documentation suggests the parties didn't intend a true debtor-creditor relationship.
Family Dysfunction
Loans between family members who don't speak or have contentious relationships raise red flags. The IRS questions whether a lender would realistically extend credit to someone they've been feuding with for years.
Loan Forgiveness and Estate Tax Consequences
Many families intend to forgive loans in their estate plan, but forgiveness timing matters significantly for tax purposes.
When you forgive a family loan during life, the unpaid balance becomes a taxable gift. If the balance exceeds the annual exclusion ($19,000 in 2025), you must file Form 709 and apply the forgiveness against your lifetime exemption.
Strategic Forgiveness Approach
| Loan Balance | Strategy | Tax Consequence | Timing |
|---|---|---|---|
| $50,000 | Wait until balance drops below $19,000 | None | Year 3-4 |
| $200,000 | Forgive $19,000 per year | Uses annual exclusion only | 11 years |
| $500,000 | Estate forgiveness at death | Included in estate | At death |
| $500,000 | Immediate gift + lifetime exemption | Uses lifetime exemption | Immediate |
$50,000 Loan Balance
$200,000 Loan Balance
$500,000 Loan Balance (Option 1)
$500,000 Loan Balance (Option 2)
Wait until the loan balance drops below the annual exclusion before forgiving. For a $100,000 loan with annual payments of $15,000, you could forgive the loan in year six when the balance reaches $18,000 or less, avoiding any gift tax filing requirements.
Alternatively, structure your estate plan so the loan is forgiven at death. The outstanding balance becomes part of your taxable estate, but this may be preferable to using lifetime exemption, especially if you're well below estate tax thresholds.
Borrower Tax Considerations
The borrower faces potential tax consequences too. When a loan is forgiven, the IRS may consider the forgiven amount as cancellation of debt income to the borrower, particularly for loans used for business purposes. Family loans structured as gifts from inception typically avoid this complication.
Working With Financial Advisors on Family Loans
Given the intersection of income tax, gift tax, estate tax, and potential capital gains implications, families benefit from professional guidance when considering loans above $50,000.
A comprehensive analysis should examine current AFR rates, the borrower's expected investment returns, both parties' tax brackets, estate tax exposure, and family dynamics around money. At Bogart Wealth, we integrate intrafamily loan strategies with our clients' broader wealth management and estate planning objectives.
The right approach varies dramatically based on your specific situation. Some families benefit more from outright gifts, others from traditional loans, and high-net-worth families may find sophisticated trust-based lending most effective.
Get Expert Guidance on Intrafamily Loans
We can help you maximize the value of intrafamily loans so they advance rather than hinder your estate planning efforts. Bogart Wealth is committed to helping you preserve your wealth and pass it on to the next generation.
Schedule a ConsultationFrequently Asked Questions About Family Loans
Which AFR rate should I use for my family loan?
The AFR rate depends on your loan term. According to IRS Revenue Ruling 2025-24, use the short-term rate (3.66%) for loans under 3 years, mid-term rate (3.79%) for 3-9 year loans, and long-term rate (4.55%) for loans over 9 years. Lock in the AFR for the month you initiate the loan, and that rate remains fixed for the entire term.
Can I loan money to a family member tax-free?
Yes, for loans under $10,000 where proceeds aren't used for income-producing investments. Above $10,000, you must charge at least the AFR to avoid imputed interest being treated as a taxable gift. However, you'll pay income tax on the interest you receive, and the borrower can only deduct interest in specific situations like business use or mortgage payments.
Do I need to report a family loan to the IRS?
The lender must report all interest received as income on their tax return. If the loan exceeds $10,000 and you don't charge adequate interest, you may need to file Form 709 to report imputed interest as a gift. The borrower doesn't report the loan proceeds as income, but they must document the loan properly to avoid IRS reclassification.
What happens if the borrower defaults on a family loan?
If you want to claim a bad debt deduction, you must prove you made good-faith efforts to collect. Document all collection attempts and maintain evidence that you intended the transaction to be a loan, not a gift. Without proper documentation and collection efforts, the IRS may disallow your bad debt deduction and recharacterize the entire transaction as a gift.
How does a family loan affect my estate tax exemption?
A properly structured family loan doesn't reduce your lifetime estate tax exemption because you're making a loan, not a gift. The outstanding loan balance remains in your estate at death, but any investment growth the borrower achieves above the AFR transfers wealth without using your exemption. This makes family loans powerful for high-net-worth families approaching the $13.99 million exemption limit.
Should I use a lawyer for a family loan agreement?
For loans over $50,000, separate legal representation for both parties strengthens the loan's legitimacy with the IRS. An attorney ensures your agreement includes all necessary terms, complies with state law, and documents both parties' intent to create a genuine debtor-creditor relationship. The upfront cost provides significant protection during potential IRS audits or estate settlement.
Ready to Explore Family Loan Strategies?
Family loans offer compelling opportunities for wealth transfer and estate planning, but they require careful structuring to comply with IRS requirements. Our team at Bogart Wealth can help you determine whether a family loan aligns with your financial objectives and guide you through proper implementation.
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