Family Loans: How to Lend Money to Relatives the Right Way

Quick Answer

The IRS requires you to charge at least the Applicable Federal Rate (AFR)—currently around 5% for short-term loans in 2026—when lending money to family members. If you charge less or nothing, the IRS will impute the difference as interest income to you and treat it as a gift to the borrower, potentially triggering gift tax reporting. A written promissory note, consistent interest payments, and documented repayment records are essential to prove the loan is legitimate and not a disguised gift.

IRS Applicable Federal Rates: Why You Must Charge Interest

The IRS publishes monthly Applicable Federal Rates (AFRs) to establish minimum interest rates for loans between related parties. In 2026, short-term AFRs (loans under 3 years) hover around 5%, while mid-term and long-term rates are slightly higher. These rates change monthly based on market conditions.

Here's what happens if you ignore the AFR:

The imputation rule under Internal Revenue Code Section 7872 means the IRS doesn't care what you and your relative agreed to—if the written contract shows insufficient interest, the tax code steps in and assigns interest retroactively. For 2026, the annual gift tax exclusion is $18,000 per recipient, and lifetime exemption is $13.61 million (indexed for inflation). A large interest-free loan to a child could consume significant exemption space.

What Happens If You Don't Charge Interest

Let's walk through a concrete example. Suppose you lend $50,000 to your adult daughter interest-free for 5 years. Without a formal interest rate, the IRS will:

1. Impute interest at the applicable AFR (roughly 5% for a mid-term loan). That's $2,500 per year in deemed interest.
2. Treat you as the creditor: You must report $2,500 in interest income annually on your tax return, even though you never received the cash.
3. Treat your daughter as the debtor: She can deduct the interest only if the loan is secured by her principal residence (home equity loan rules).
4. Require a gift tax return: The $50,000 principal, depending on your lifetime exemption usage, may trigger Form 709 filing.

The imputation rule exists because the IRS wants to prevent wealthy families from shifting income and wealth tax-free. Without it, a parent could loan a high-income child money at 0%, letting the child use it to earn taxable investment returns, while the parent avoids reporting the implicit interest income.

How to Structure a Family Loan: Four Essentials

A defensible family loan requires four elements. Skip any one, and the IRS may argue the "loan" is actually a gift.

1. Written Promissory Note

This is non-negotiable. The note should include:

• Full names of lender and borrower
• Principal amount (e.g., "$50,000")
• Interest rate (at or above the current AFR, e.g., "5.5% annual interest")
• Loan term (e.g., "60 months, beginning June 1, 2026")
• Repayment schedule (monthly, quarterly, or lump sum on a specified date)
• Default clauses (what happens if a payment is missed)
• Signatures and date of execution

You can use a template from the Family Loan Calculator or have a lawyer draft one for a few hundred dollars. The IRS wants to see a genuine contract, not a handshake.

2. Interest Rate at or Above AFR

Check the current AFR rate on the IRS website for the month you make the loan. Short-term (under 3 years) rates in 2026 are around 5%, mid-term (3–9 years) around 5.5%, and long-term (over 9 years) around 5.7%. You can charge higher than AFR without penalty, but lower triggers imputation.

3. Repayment Schedule

Write down exactly when payments are due: "Principal and interest of $1,044.51 due on the 1st of each month, starting July 1, 2026." Monthly or quarterly payments are standard. Lump-sum repayment is acceptable but less common.

4. Payment Documentation

Every time the borrower pays, record it. If they pay by check, keep the cancelled check. If by bank transfer, keep the confirmation. Maintain a simple log:

This record proves you were running a real loan, not a gift with fuzzy terms.

Tax Reporting for Lender and Borrower

Once the loan is made correctly, here's how to report it on taxes:

For the lender (you):

• Report annual interest received as income on Form 1040, Schedule B (Interest and Ordinary Dividends). In year one of the $50,000 loan at 5.5%, you'd report roughly $2,750 in interest income.
• If interest exceeds $600 in a calendar year, the borrower must receive a Form 1099-INT, and you file a copy with the IRS.
• The loan principal is not income—only the interest is taxable.

For the borrower:

• They can deduct interest only if the loan is secured by their principal residence or used to invest in an active trade/business. A loan to buy a car or pay off credit card debt? No deduction.
• If the loan is for a home (and secured by a mortgage or second deed of trust), they might deduct the interest under the home mortgage interest deduction, subject to the $750,000 loan principal limit.

What If the Borrower Defaults?

Life happens. Your daughter loses her job, or your son's business fails. He stops making payments. What are your options?

Option 1: Forgive the Debt as a Gift

You can forgive all or part of the loan using your annual gift tax exclusion ($18,000 per recipient in 2026) or lifetime exemption. File Form 709 (Gift Tax Return) in the year of forgiveness if the amount exceeds the annual exclusion. This is emotionally cleaner and legally straightforward—you're converting the loan to a gift retroactively.

Option 2: Claim a Bad Debt Deduction

If you forgive the loan, you might be able to claim a nonbusiness bad debt deduction under IRC Section 166. However, this requires proving:

• The loan was a genuine debt (promissory note required)
• The debtor became wholly or partly worthless in the tax year you claim the deduction
• You have no reasonable prospect of recovery

Nonbusiness bad debt deductions are treated as short-term capital losses, limited to $3,000 per year against ordinary income. The process is complex and often not worth it for family loans—most people simply forgive as a gift.

Option 3: Pursue Legal Remedies

You can sue to enforce the promissory note. This is nuclear, strains family relationships, and costs money in legal fees. But if the borrower has assets, a court judgment gives you a claim against those assets. Small claims court works for loans under $10,000 (limits vary by state); larger loans go to civil court.

Family Loan vs. Gift: Comparison Table

Confused about whether to loan or gift? Here's how they stack up:

Frequently Asked Questions

Q: Can I loan to my adult child interest-free and just not report it to the IRS?

A: Technically, the IRS allows interest-free loans under certain circumstances—but only if the loan balance never exceeds $10,000 at any time during the year (the de minimis rule under IRC Section 7872(c)(3)). Above $10,000, the AFR interest is mandatory. Even below $10,000, it's risky to assume the IRS won't ask questions if audited. A written agreement at market rate removes all doubt.

Q: Do I need a lawyer to write the promissory note?

A: No, but it helps for large loans (over $50,000). For smaller family loans, a template from a reputable source like a bank or the Small Business Administration is fine. The key is that the note is written, signed, and specific about rate and terms. Using the Family Loan Calculator can generate a basic note compliant with AFR rules.

Q: What if the borrower doesn't have a job and can't really repay?

A: That's not a loan—it's a gift. If you don't expect repayment, don't pretend it's a loan to avoid gift tax reporting. Instead, file Form 709, report it as a gift, and move on. Hiding a gift as a fake loan to dodge gift tax is tax fraud. If audited and the IRS determines repayment was never realistic, they'll reclassify it as a gift anyway, and you could face penalties and interest.

Q: If I charge AFR interest, do I owe FICA or self-employment taxes on it?

A: No. Interest income from a loan is not subject to self-employment tax. You report it as ordinary income, but it's not covered by FICA (Social Security and Medicare). Only if you're in the business of lending (like a bank or lending company) would you owe FICA.

Q: Can my child deduct the interest if the loan funds a down payment on a rental property?

A: Possibly. If the loan is used to purchase an investment property and is secured by that property (like a second mortgage), the interest may be deductible as an investment expense. The rules are nuanced—consult a tax professional. Use a clear promissory note so the documentation trail is clean.

Sources

• IRS Publication 550: Investment Income and Expenses
• IRC Section 7872: Below-Market Loans
• IRS Applicable Federal Rates (Monthly)
• IRS Form 709: United States Gift (and Generation-Skipping Transfer) Tax Return
• Small Business Administration: Business Loan Documents