How to Borrow Money From Family: AFR Rates, Notes, and Taxes

When you borrow money from a family member, the IRS treats the transaction as a real loan only if it carries interest at or above the Applicable Federal Rate and is backed by a written agreement the two of you actually follow. Miss either piece and the agency can reclassify the money as a gift, with tax consequences for the lender and a paperwork mess for both of you. The rules for borrowing money from family under IRS guidelines are not complicated, but they are specific, and getting them right protects the lender’s tax position and the borrower’s ability to deduct interest if the loan is tied to a home.

The Minimum Interest Rate: Applicable Federal Rates

The single most important number in an intra-family loan is the interest rate. Any loan between family members that charges less than the AFR is a “below-market loan,” which triggers imputed interest rules and possible gift tax consequences.¹

The IRS publishes new AFR figures every month in three tiers based on the loan’s repayment term:²

Short-term (3 years or less): 3.57% for January 2026, monthly compounding
Mid-term (over 3 years, up to 9 years): 3.74% for January 2026
Long-term (over 9 years): 4.54% for January 2026

You lock in the rate published for the month you fund the loan, not the month you sign the note.³ Charging more than the AFR is fine. Charging less is what creates the tax problems described below.

When the Rules Relax for Smaller Loans

Not every family loan gets hit with the full imputed-interest treatment. Federal law carves out two exceptions based on size.

If the total outstanding balance between the lender and borrower stays at or below $10,000, the below-market loan rules don’t apply. The exception disappears if the borrower uses the money to buy income-producing assets like stocks or rental property.¹

For gift loans between $10,001 and $100,000, the imputed interest the IRS can tax the lender on is capped at the borrower’s actual net investment income for the year. If that net investment income is $1,000 or less, it’s treated as zero, meaning no imputed interest at all. This exception also disappears if one of the main purposes of the arrangement is avoiding federal tax.¹

The thresholds look at the aggregate balance between the same two people. Lend your brother $8,000 today and another $5,000 next month, and the combined $13,000 puts you outside the $10,000 safe harbor.

What Belongs in the Promissory Note

A promissory note is what turns a family arrangement into a legal obligation. Without one, the IRS has an easy time reclassifying the transfer as a gift, and the lender has almost no leverage if payments stop. The note should include:

Full legal names and addresses of both parties
Social Security numbers for both parties, needed for tax reporting
The principal amount
An interest rate at or above the AFR for the loan’s term
A repayment schedule with specific due dates
The maturity date when the full balance must be paid
Late payment terms, commonly around 5% of the overdue installment
Default provisions describing what happens if the borrower stops paying

Templates are widely available. What matters is filling in an AFR-compliant rate and a schedule both sides will actually follow. A note sitting in a drawer with no payments coming in looks like a gift, and the IRS knows the difference.

If the Loan Is Secured by a Home

Where the loan is tied to real estate, the note alone isn’t enough. You’ll need a mortgage or deed of trust (which one depends on your state), and it must be recorded with the county recorder’s office. Recording fees commonly run $50 to $150. Recording is not optional if the borrower wants to claim a mortgage interest deduction: the IRS requires the security instrument to be “recorded or otherwise perfected under any state or local law that applies.”⁴

Moving the Money and Keeping Records

Both parties should sign the note in front of a notary. Notarization isn’t legally required in most states, but it prevents either side from later claiming a signature isn’t theirs.

Transfer the money through a method that creates a paper trail. Wire transfers, certified checks, and direct bank-to-bank transfers all work. Cash does not. If the IRS ever questions the loan, you need a bank record showing a specific amount moving between two specific people on a specific date. Keep the signed note, the transfer receipt, and every payment record in one file. The lender should track each payment with date, amount, and the split between principal and interest.

What the Lender Owes the IRS

Interest Income

Interest a lender receives on a family loan is taxable income, reported on the federal return the same way bank interest would be. If the borrower pays more than $10 in interest during the year, the lender is required to file Form 1099-INT and send copies to both the borrower and the IRS.⁵ Even below that threshold, the tax on the income is still owed.

Imputed Interest on Below-Market Loans

Charge less than the AFR and the IRS treats the gap between what you charged and what the AFR would have produced as “forgone interest.” That phantom income is taxable to the lender even though it was never actually collected.¹

Say you lend your daughter $50,000 for five years at 1% interest when the mid-term AFR is 3.74%. You collect $500 a year in actual interest, but the IRS treats roughly $1,870 as the interest you should have collected. The $1,370 difference is imputed interest that you report as income. The same amount is also treated as a gift from you to her, which pulls gift tax rules into the picture.

Form 1098 Usually Doesn’t Apply

Family lenders generally do not have to file Form 1098 (Mortgage Interest Statement) because that filing obligation applies only to lenders receiving mortgage interest “in the course of a trade or business.” The instructions specifically note that holding a mortgage on a former personal residence and collecting payments doesn’t trigger a filing requirement.⁶ The borrower can still deduct the interest without a 1098, but has to report it separately on Schedule A and provide the lender’s taxpayer identification number.

When the Borrower Can Deduct the Interest

Interest paid on a family loan is generally not deductible. The main exception is when the loan is secured by the borrower’s primary or secondary residence, in which case the interest can be deducted as home mortgage interest. To qualify, all of the following must be true:⁴

A security instrument (mortgage or deed of trust) is signed and recorded with the county
Both parties intend the loan to be repaid, and actual payments are being made
The borrower itemizes on Schedule A instead of taking the standard deduction
For loans originated after December 15, 2017, the deduction is limited to interest on the first $750,000 of mortgage debt ($375,000 if married filing separately)

Because a family lender almost certainly won’t file Form 1098, the borrower reports the interest on Schedule A, line 8b, and includes the lender’s name, address, and Social Security number or taxpayer identification number. Leaving out the lender’s TIN can trigger a $50 penalty.⁴

Where Gift Tax Comes In

Gift tax rules touch every family loan in two distinct ways.

The first is forgone interest. When you charge below the AFR, the difference is treated as a gift from the lender to the borrower. On a large loan, that phantom gift can exceed the annual gift tax exclusion, which is $19,000 per recipient for 2026.⁷ If total gifts to one person in a calendar year (imputed interest included) exceed $19,000, the lender must file Form 709, the federal gift tax return.⁸

The second is reclassification. With no written note, no repayment schedule, and no payments actually being made, the IRS can treat the entire transfer as a gift. A $50,000 “loan” with no documentation and no payments is, in the agency’s view, a $50,000 gift. That blows past the annual exclusion and eats into the lender’s lifetime gift and estate tax exemption.

Filing Form 709 does not automatically mean gift tax is owed. The form reports the gift and reduces the lifetime exemption. Skipping it when required can bring penalties and IRS attention.⁹

If the Lender Forgives the Loan

Sometimes a lender decides to write off part or all of the balance. The tax consequences land differently on each side.

For the lender, the forgiven amount is a gift. Forgive $30,000 and you have made a $30,000 gift; the amount above the $19,000 exclusion is reported on Form 709 and reduces the lifetime exemption.⁸ Forgiving the loan in annual pieces that each stay within the exclusion avoids using any lifetime exemption.

For the borrower, canceled debt normally counts as taxable income. Forgiveness that qualifies as a gift is specifically excluded from that rule.¹⁰ Since a family member forgiving a loan is almost always a gift, the borrower usually owes no income tax on the forgiven amount. The IRS lists “amounts canceled as gifts, bequests, devises, or inheritances” as an exception to the general canceled-debt rule.¹¹

Family lenders generally don’t file Form 1099-C (Cancellation of Debt), because that form is required only of financial institutions and entities whose significant trade or business is lending money.¹²

Mistakes That Turn a Loan Into a Gift

Most family loans that run into IRS trouble fail in one of a few predictable ways.

No written agreement. The IRS presumes a transfer between family members is a gift unless you can prove otherwise. A signed promissory note with an AFR-compliant rate is the proof.
Zero interest on a large loan. A $100,000 interest-free loan to an adult child with meaningful investment income can generate thousands in imputed interest and gift tax consequences neither side saw coming.
Ignoring the repayment schedule. A perfect note looks like a sham if nobody follows it. Consistent, documented payments on the dates in the note are what keeps a loan a loan.
Using cash. If you can’t show the money moved from one bank account to another, you can’t prove the loan exists.
Skipping the interest income on the lender’s return. The lender owes tax on every dollar of interest received, and on imputed interest for below-market loans. This is the reporting step people miss most often, and it’s exactly what draws an audit.

Handled like a real financial transaction, an intra-family loan is straightforward. The paperwork takes an afternoon, and the tax reporting adds a few lines to a return each year. That is a small price compared with a gift tax dispute or a family argument over money nobody wrote down.

1
Office of the Law Revision Counsel. 26 USC 7872 Treatment of Loans With Below-Market Interest Rates
2
Internal Revenue Service. Applicable Federal Rates
3
Internal Revenue Service. Rev. Rul. 2026-2 Applicable Federal Rates for January 2026
4
Internal Revenue Service. Publication 936 (2025), Home Mortgage Interest Deduction
5
Internal Revenue Service. About Form 1099-INT, Interest Income
6
Internal Revenue Service. Instructions for Form 1098 Mortgage Interest Statement
7
Internal Revenue Service. What’s New – Estate and Gift Tax
8
Internal Revenue Service. Instructions for Form 709 (2025)
9
Internal Revenue Service. Frequently Asked Questions on Gift Taxes
10
Office of the Law Revision Counsel. 26 USC 108 Income From Discharge of Indebtedness
11
Internal Revenue Service. Topic No. 431 Canceled Debt – Is It Taxable or Not?
12
Internal Revenue Service. Instructions for Forms 1099-A and 1099-C (Rev. April 2025)