Yes — a family member can loan you money to buy a house, and the arrangement is legal under federal law as long as you treat it like a real loan. That means a written promissory note, an interest rate at least equal to the IRS Applicable Federal Rate, a repayment schedule both sides actually follow, and honest tax reporting each year. Skip those pieces and the IRS can recharacterize the whole transaction as a gift, which creates tax problems for the lender and can jeopardize a separate bank mortgage for the borrower.
What the Loan Agreement Has to Include
The written promissory note is the document that turns money changing hands into a legally recognized loan. Without one, the IRS can treat the funds as a gift, and a primary mortgage lender may flag them as an undisclosed liability. The note is also what you’d rely on if the relationship breaks down and the debt ends up in court.
At a minimum, the agreement should spell out:
- The principal amount borrowed.
- The interest rate, at or above the current Applicable Federal Rate.
- A repayment schedule with specific due dates.
- A maturity date for full repayment.
- Default terms, including late fees or acceleration of the balance.
- Whether the loan is secured by a lien on the property.
Both parties sign. Notarizing adds credibility if anyone later questions whether the agreement is real. If the borrower wants to deduct the interest, the loan has to be secured by a recorded lien, which means filing a separate mortgage or deed of trust with the county recorder’s office. Recording fees vary by county but are minor.
The Minimum Interest Rate the IRS Requires
You can’t lend money to a relative interest-free (or at a token rate) without tax consequences. Under 26 U.S.C. § 7872, a family loan that charges less than the Applicable Federal Rate is a “below-market loan,” and the IRS will impute the missing interest as though it had actually been paid.1Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans with Below-Market Interest Rates The lender owes income tax on interest they never received, and the shortfall between what was charged and the AFR is treated as a gift from lender to borrower.
The AFR is published monthly and broken into three tiers under 26 U.S.C. § 1274(d):2Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
- Short-term (3 years or less): 3.59% annually as of March 2026.
- Mid-term (over 3 years, up to 9 years): 3.93% annually.
- Long-term (over 9 years): 4.72% annually.
These figures come from IRS Revenue Ruling 2026-6.3Internal Revenue Service. Rev. Rul. 2026-6 – Applicable Federal Rates for March 2026 Since most home loans run longer than nine years, the long-term AFR is usually the one that applies. The rate locks in on the day the note is signed and stays fixed for the life of the loan.
Small-Loan Exceptions
Two exceptions can spare small lenders the imputed-interest rules entirely.
If the total outstanding balance between the two parties stays at or below $10,000, the below-market rules under § 7872 don’t apply. The lender can charge zero interest without gift tax or imputed income consequences. The exception disappears if the loan is used to buy income-producing assets like a rental property or investments.4Office of the Law Revision Counsel. 26 U.S. Code 7872 – Treatment of Loans with Below-Market Interest Rates For a primary residence you’ll live in, the safe harbor works, but $10,000 rarely funds a home purchase on its own.
For loans between $10,001 and $100,000, the imputed interest for income tax purposes is capped at the borrower’s net investment income for the year. If the borrower’s net investment income is $1,000 or less, the IRS treats it as zero, which effectively eliminates the income tax hit. The exception falls away if a principal purpose of the interest arrangement is tax avoidance, or if the total loans between the two parties exceed $100,000.4Office of the Law Revision Counsel. 26 U.S. Code 7872 – Treatment of Loans with Below-Market Interest Rates
Even when the income tax side gets favorable treatment, the gift tax rules can still apply separately. If the forgone interest exceeds the $19,000 annual gift tax exclusion for 2026, the lender may need to file a gift tax return. No actual gift tax comes due unless the lender has used up their $15,000,000 lifetime exemption, but the filing obligation still exists.5Internal Revenue Service. What’s New — Estate and Gift Tax
If You’re Also Getting a Bank Mortgage
Your bank will treat the family loan as a real liability. Every debt has to be disclosed on the Uniform Residential Loan Application (Fannie Mae Form 1003), including loans from relatives that never appear on a credit report.6Fannie Mae. Instructions for Completing the Uniform Residential Loan Application Hiding a family loan is mortgage fraud. Under 18 U.S.C. § 1344, penalties reach $1,000,000 in fines, up to 30 years in prison, or both.7Office of the Law Revision Counsel. 18 USC 1344 – Bank Fraud
The monthly payment on the family loan folds into your debt-to-income ratio. Fannie Mae’s automated underwriting allows a maximum DTI of 50%; manually underwritten loans start at a 36% baseline and can stretch to 45% for borrowers with strong credit and reserves.8Fannie Mae. Debt-to-Income Ratios If the family payment pushes you past those limits, the bank will lend you less. A family loan that funds your entire down payment shrinks your purchasing power more than a gift would, because a gift creates no ongoing repayment obligation and typically just requires a signed gift letter.
Timing matters too. Large deposits made within 60 days of a mortgage application aren’t considered seasoned funds, so you’ll need to document the source with a copy of the promissory note, transfer records, and sometimes a letter from the family lender explaining the terms. Depositing the money well before you apply reduces the paper trail.
What the Lender Has to Report
Interest received on a family loan is taxable income, reported on Schedule B of Form 1040.9Internal Revenue Service. Instructions for Schedule B (Form 1040) The lender pays their ordinary income tax rate on every dollar collected. If the interest charged came in below the AFR, the shortfall is treated as a gift to the borrower, and the lender may need to file Form 709.10Internal Revenue Service. Instructions for Form 709
There’s also an information-reporting obligation. If the borrower pays $10 or more in interest during the year, the lender is required to issue a Form 1099-INT.11Internal Revenue Service. About Form 1099-INT, Interest Income That threshold catches most family loans of any real size. Many family lenders don’t realize the form is required, and skipping it is one of the fastest ways to draw IRS scrutiny to the whole arrangement.
When the Borrower Can Deduct the Interest
Borrowers can deduct interest on a family loan the same way they’d deduct bank mortgage interest, but only if the loan is “secured” by the property. That means a mortgage, deed of trust, or similar instrument has to be signed and recorded (or otherwise perfected) under your state’s law.12Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction A promissory note sitting in a desk drawer doesn’t qualify. The security instrument has to be on file with the county recorder.
Even with a properly recorded lien, the deduction applies only to acquisition indebtedness up to $750,000 ($375,000 if married filing separately).13Office of the Law Revision Counsel. 26 U.S. Code 163 – Interest That cap covers all mortgage debt on your primary and secondary residences combined. If you already have a $600,000 bank mortgage and add a $200,000 family loan, only the interest on the first $150,000 of the family loan is deductible. You also have to itemize on Schedule A rather than take the standard deduction, so the benefit only pays off when your itemized total exceeds the standard.
If the Borrower Stops Paying
Default is where family loans get genuinely painful, and what happens next depends on whether the loan is secured.
If the lender recorded a lien, they have the legal right to foreclose, following the same process a bank would: judicial foreclosure in some states, a trustee sale in others. Most families would rather work out a modified payment plan than foreclose on a relative, but the lien gives the lender real leverage and protects their position if the borrower sells or refinances.
If the loan is unsecured and the borrower simply stops paying, the lender’s main tax remedy is a nonbusiness bad debt deduction. The IRS allows it only when the debt is completely worthless, not just past due, and the lender has to show reasonable collection efforts. It’s reported as a short-term capital loss on Form 8949, which offsets capital gains first and then up to $3,000 of ordinary income per year, with excess losses carried forward. The lender must attach a detailed statement describing the debt, the relationship, and the collection steps taken.14Internal Revenue Service. Topic No. 453, Bad Debt Deduction
One risk trips families up. If the IRS decides the lender never genuinely expected repayment, the whole transaction gets reclassified as a gift from the beginning. That wipes out the bad debt deduction and can trigger gift tax filing obligations depending on the size. Documenting the loan properly at the outset, charging at least the AFR, and keeping records of actual payments are the best defenses against that recharacterization. If the loan is large enough to matter at tax time, it’s large enough to set up correctly.