To loan money to family legally, you need a signed promissory note, an interest rate at or above the IRS Applicable Federal Rate, a traceable transfer of funds, and a written record of every payment. Skip any of those, and the IRS can treat the money as a gift instead of a loan, and you lose the ability to enforce repayment if the relationship sours. The paperwork feels awkward the first time you raise it, but it protects the borrower as much as the lender.
Agree on the Terms Before Money Moves
Sit down together and settle the basics in writing before any funds change hands. You need the exact principal, a repayment schedule with specific due dates and dollar amounts, and a final payoff date. The schedule can be monthly or quarterly installments, a single lump sum on a future date, or smaller payments leading to a balloon at the end. Whatever structure you pick, the numbers and dates need to be specific.
Decide whether the loan is secured or unsecured. An unsecured loan rests on the borrower’s promise. A secured loan is backed by a specific asset, such as a vehicle or a piece of equipment, that you can claim if the borrower defaults. If you go secured, the collateral has to be identified in the loan agreement, and the security interest generally needs to be filed as a financing statement or recorded as a lien through your state’s motor vehicle or property recording office to be enforceable against other creditors. Filing procedures and fees vary by state, so check with your local agency first.
Charge at Least the Applicable Federal Rate
Charging interest feels uncomfortable inside a family, but the IRS expects it. If you charge nothing or too little, the IRS calculates what you should have charged at the Applicable Federal Rate (AFR) and treats that phantom amount as taxable interest income to you. The AFR is published monthly and has three tiers based on how long the loan runs:
- Short-term (three years or less): 3.56% as of February 2026
- Mid-term (over three years, up to nine): 3.86%
- Long-term (over nine years): 4.70%
Those figures come from the February 2026 revenue ruling, and the IRS updates them every month.{CITE1} The statutory breakpoints for the three tiers come from the Internal Revenue Code.{CITE2} Check the current month’s rate before you finalize the note, because using a stale rate creates the same imputed-interest problem as charging nothing.
Every state also sets a legal ceiling through usury laws. The caps vary widely, and violating them can void the loan or expose you to penalties. If you plan to charge above the AFR, confirm your rate stays below your state’s maximum.
Two exceptions cut the tax headache for smaller loans. If the total you have outstanding to the borrower is $10,000 or less on any given day, the imputed interest rules don’t apply.{CITE3} For loans between $10,001 and $100,000, the imputed interest the IRS can charge you in a year is capped at the borrower’s net investment income for that year, and if that income is $1,000 or less, it’s treated as zero.{CITE4} Neither exception applies if one of the principal purposes of the interest arrangement is tax avoidance.{CITE5}
Put It in a Promissory Note
Once terms are settled, document them in a promissory note. This is the borrower’s written promise to repay, and it’s what makes the loan legally enforceable. A workable promissory note includes:
- Full legal names and addresses of both lender and borrower
- The principal amount
- The interest rate and how it’s calculated (simple or compound, annual or monthly)
- A repayment schedule with specific due dates, payment amounts, and final payoff date
- Late payment terms, including any grace period and late fee
- A description of any collateral
- Default provisions spelling out what counts as default and what happens next
Templates are available through legal form websites and document preparation services. Read every clause before filling one in, because generic templates sometimes carry provisions that conflict with your state’s laws or don’t fit your situation. For loans above $10,000 or loans secured by real property, having an attorney review the note is worth the cost.
Sign, Notarize, and Store the Note
Both parties sign and date the note. Federal law recognizes electronic signatures as legally valid for contracts, so a reputable e-signature platform works if you’re in different locations.{CITE6} Some states impose specific rules on certain secured transactions, so e-signatures are safest for standard unsecured notes.
Notarization isn’t legally required in most situations, but it’s worth the small cost. A notary verifies each signer’s identity through government-issued photo ID and witnesses the signatures, which makes it much harder for anyone to later claim they didn’t sign or were pressured. Fees for a standard acknowledgment typically run $5 to $25 depending on the state. If the loan ends up in court, a notarized document carries more weight.
Each party keeps a signed original or a certified copy. Store yours with your other important financial records.
Transfer the Money So It’s Traceable
Move the funds in a way that creates a paper trail: a bank wire, an ACH transfer, or a personal check. Avoid cash. If the IRS ever questions whether the transaction was a loan or a gift, a traceable transfer paired with a signed promissory note is your strongest evidence.
Throughout the life of the loan, keep a payment ledger. Record the date and amount of each payment, how it was received, and the remaining balance. A simple spreadsheet is fine. That log keeps both parties honest and provides the documentation you’d need for a bad debt deduction or to defend the loan’s legitimacy to the IRS.
The Loan-vs-Gift Test
The IRS draws a hard line between loans and gifts. A loan involves a genuine expectation of repayment; a gift does not. If a family transfer lacks a written agreement, charges no interest, and shows no repayment history, the IRS can reclassify the entire amount as a gift, which can trigger gift tax reporting and eat into your lifetime exemption.{CITE7}
Courts look for a signed promissory note, a fixed repayment schedule, actual payments being made, an interest rate at or above the AFR, and the borrower’s realistic ability to repay. The more of these you have, the stronger the position. The absence of any one of them, especially actual repayment activity, gives the IRS an opening.
Report the Interest You Receive
Interest you actually receive on a family loan is taxable income. Report it on Schedule B of your Form 1040, listing the borrower’s name and total interest received during the year.{CITE10} You won’t get a 1099-INT because the borrower isn’t a financial institution, so your own ledger is what you’ll use to calculate the amount.
If you charge below the AFR on a loan over $10,000 and the small-loan exceptions don’t apply, the IRS imputes the difference: the amount you would have earned at the AFR is treated as taxable interest income to you.{CITE8} That same imputed amount can also be treated as a gift to the borrower. For 2026, the annual gift tax exclusion is $19,000 per recipient.{CITE9} As long as imputed interest stays below that threshold, no gift tax return is needed. Amounts above it get reported on Form 709.
If the Borrower Stops Paying
Try to Collect First
A promissory note gives you the legal right to sue for the unpaid balance, but suing a family member is rarely anyone’s first choice. Start with a written demand letter that references the note, states the overdue amount, and sets a deadline. Mediation through a neutral third party can sometimes resolve the standoff without court. Keep copies of every communication as evidence of your collection efforts.
Every state imposes a statute of limitations on enforcing a written promissory note, typically three to six years, though some states allow longer. Once the deadline passes, you lose the right to sue no matter how airtight the note is. Don’t wait years to act.
Claim a Bad Debt Deduction
If the borrower genuinely cannot repay and you’ve made reasonable collection efforts, you can claim a nonbusiness bad debt deduction. The IRS requires the debt to be totally worthless; partial losses on personal loans aren’t deductible.{CITE11} You also need to show you intended to make a loan (not a gift) at the time of the transaction and that you tried to collect before writing it off.
A nonbusiness bad debt is treated as a short-term capital loss on Form 8949.{CITE12} That means it offsets capital gains dollar for dollar, but only $3,000 per year against ordinary income, with any excess carried forward. Your return needs a detailed statement explaining the debt, the borrower’s name, your relationship, your collection efforts, and why you determined the debt was worthless.{CITE13}
Forgive the Loan
If you decide to forgive what’s owed, the tax consequences split between you and the borrower. On your side, forgiveness is treated as a gift, and if the forgiven amount exceeds the $19,000 annual exclusion for 2026, you file Form 709.{CITE14}
For the borrower, canceled debt is generally taxable income, but there’s a statutory exception for amounts canceled as gifts.{CITE15} When a family member voluntarily forgives a debt, the IRS usually treats it as a gift and the borrower owes no income tax on the forgiven amount.{CITE16} To make this clean, execute a written release that references the original note, states you’re releasing the borrower from all remaining obligations, and is signed and dated.
If the Borrower Files Bankruptcy
If your borrower files Chapter 7, any unsecured debt they owe you is grouped with the claims of other unsecured creditors. Family members are classified as insiders under bankruptcy law, and the trustee can look back a full year before the filing date to claw back payments the borrower made to you during that period if the borrower was insolvent at the time.{CITE17} For non-family creditors, that look-back window is only 90 days. The borrower has to list your loan in the petition. If the debt is discharged, you lose the legal right to collect, though the borrower may still choose to repay voluntarily. A secured loan with a properly recorded lien puts you in a stronger position.