How to Set Up a Personal Loan With a Family Member

To set up a personal loan with a family member the right way, charge at least the Applicable Federal Rate (AFR) in interest, put the terms in a written promissory note both parties sign, transfer the money through a bank record you can trace, and keep a ledger of every payment. Do those four things and the IRS will treat the arrangement as a real loan rather than a disguised gift, and both sides will have the paperwork they need at tax time.

The rest is detail, but the details matter. Miss the interest rate and the lender can owe tax on interest they never collected. Skip the written note and a soft repayment plan can quietly turn into a taxable gift. Here’s how to build the loan so it holds up.

Charge at Least the Applicable Federal Rate

Under Internal Revenue Code Section 7872, any loan between family members that charges less than the AFR is a “below-market loan,” and the IRS treats the gap between what you charged and what you should have charged as a gift from the lender to the borrower.¹ That phantom gift can trigger gift tax reporting and force the lender to pay income tax on interest they never actually received.

The IRS publishes AFRs monthly, and the rate you need depends on how long the loan runs. Section 1274(d) sets three tiers:²

Short-term: loans of three years or less
Mid-term: loans longer than three years but not more than nine years
Long-term: loans longer than nine years

For reference, the January 2026 AFRs compounded annually were 3.63% for short-term, 3.81% for mid-term, and 4.63% for long-term loans. These rates change every month, so check the IRS Index of Applicable Federal Rates for the month you actually sign the note, not the month you started talking about the loan.

Decide Between a Demand Loan and a Term Loan

A demand loan has no fixed repayment date, and the lender can call the balance at any time. A term loan has a set maturity date and a defined repayment schedule. The IRS handles imputed interest differently for each, and the choice matters more than most people expect.

On a demand loan, the IRS recalculates imputed interest every year using the short-term AFR in effect during that period, with the forgone interest treated as transferred on the last day of each calendar year.¹ If rates rise, so does the lender’s phantom interest income.

On a term loan, you lock in the AFR on the date the loan is made, and that rate applies for the entire life of the loan.¹ Sign a five-year note when the mid-term AFR is 3.81%, and 3.81% is your benchmark for all five years. For most families, the term loan is the simpler choice. It also forces both sides to agree on a timeline up front, which avoids the awkward “when am I getting my money back” conversation later.

Know the $10,000 and $100,000 Exceptions

Not every family loan triggers the full weight of the imputed interest rules.

For loans of $10,000 or less, Section 7872 does not apply, as long as the borrower doesn’t use the money to buy income-producing assets like stocks or rental property.¹ A $10,000 interest-free loan for a car repair or a medical bill is fine. A $10,000 interest-free loan the borrower drops into a brokerage account is not.

The $100,000 exception is less well known and covers the range most family loans fall into. When the total outstanding balance between the two individuals stays at or below $100,000, imputed interest is capped at the borrower’s net investment income for the year.³ If the borrower earned $800 in dividends and interest that year, the IRS imputes at most $800 to the lender. And if the borrower’s net investment income is $1,000 or less, it’s treated as zero, meaning an interest-free loan up to $100,000 can effectively generate no imputed interest at all.

The exception disappears the moment the balance crosses $100,000, and it doesn’t apply if a principal purpose of the arrangement is tax avoidance.³

Put the Terms in a Promissory Note

A written promissory note is what separates a loan from a gift in the eyes of the IRS and a court. Without one, the lender has almost no legal recourse if the borrower stops paying, and the IRS has every reason to recharacterize the whole amount as a taxable gift.

The note should include the full legal names and addresses of both parties, the exact principal amount, and the date the loan is executed. Beyond those basics, it needs:

The interest rate, which must meet or exceed the AFR for the loan’s term in the month the note is signed. Specify whether interest compounds annually, semiannually, quarterly, or monthly, and match the rate to the corresponding AFR column.
A repayment schedule. Monthly installments are most common, but quarterly payments or a lump sum at maturity also work. Each payment should be allocated between principal and interest.
A maturity date, which is the specific day the full remaining balance comes due. This keeps the loan from looking like an open-ended gift.
Late payment terms, either a flat fee or a percentage charge for overdue payments, plus a grace period if you want one.
Default provisions covering what happens if the borrower misses multiple payments, typically giving the lender the right to demand the full remaining balance immediately.

Every term should reflect what both parties actually intend to do. If the note says monthly payments but the actual pattern is two lump deposits a year, the arrangement starts to look like a gift dressed up as a loan.

Sign, Notarize, and Store the Note

A promissory note doesn’t legally require notarization to be enforceable in most states. Both parties sign, and the note is binding. That said, notarization is worth the small cost because a notary verifies both identities and confirms the signatures were given voluntarily, which makes it harder for either side to walk back the terms later. Notary fees for a simple acknowledgment typically run $5 to $25 depending on your state.

Both the lender and the borrower should keep original signed copies somewhere secure, whether that’s a safe, a filing cabinet, or a scan backed up to cloud storage. The note is what you’ll need for tax preparation and for any legal proceeding if the loan goes bad.

Transfer the Money Through a Traceable Method

Move the funds by bank wire, ACH transfer, or certified check. Cash is a nonstarter. If the IRS ever questions whether a loan was actually made, you want a bank record showing the exact amount leaving the lender’s account and arriving in the borrower’s on a specific date.

Once the money is transferred, the lender should start a payment ledger recording every incoming payment, the date received, and how much went to principal versus interest. A simple spreadsheet is enough. That ledger becomes the backbone of the lender’s tax reporting and the best evidence that both sides treated the arrangement as a real loan.

Secure the Loan If It’s for a Home

For larger loans, especially those used to buy real estate, securing the loan with collateral protects the lender and can open up a tax benefit for the borrower.

If the borrower is buying real estate, the lender can hold a mortgage or deed of trust on the property. The document must include a legal description of the property and give the lender the right to foreclose on default. To be legally effective, the mortgage needs to be recorded with the local county recorder’s office. Recording fees vary but generally run about $15 to $50 for the first page, with additional per-page charges.

Recording matters for taxes too. When the debt is secured by a qualified home, both parties intend the loan to be repaid, and the security instrument is properly recorded under state or local law, the borrower may deduct the interest as mortgage interest.⁴ The borrower has to itemize on Schedule A to claim it. Without a recorded mortgage, the interest on a family loan is personal interest, and personal interest is not deductible.

Report the Interest on Both Sides

The lender owes tax on interest actually collected and on any interest the IRS imputes under the below-market loan rules. Imputed interest is calculated as the difference between what the AFR would have generated and what the borrower actually paid.⁵ Charge 1% when the AFR is 3.81% and the lender owes tax on the full 3.81%, not the 1% collected.

If the borrower pays $10 or more in interest during the year, the lender is technically required to issue the borrower a Form 1099-INT.⁶ Many family lenders don’t know this. Even if you skip the form, the tax on the interest income is still owed.

On the borrower’s side, interest paid on a personal family loan is generally not deductible. Three narrow exceptions exist:

Home mortgage interest, if the loan is secured by a primary or secondary residence with a properly recorded mortgage.⁴
Business expense interest, if the borrowed funds cover legitimate business costs.
Investment interest expense, if the funds go toward taxable investments, limited to the borrower’s net investment income and only available with itemized deductions on Schedule A.

Watch the Gift Tax Line

If the lender charges below the AFR, the forgone interest is treated as a gift to the borrower. When that gift plus any other gifts to the same person during the year exceeds the annual gift tax exclusion of $19,000 for 2026, the lender has to file Form 709. Filing doesn’t necessarily mean tax is owed. It reduces the lender’s lifetime exemption, which sits at $15,000,000 per individual for 2026.⁷ Most families never come close to that ceiling, but the filing obligation still applies.

For loans priced at or above the AFR, the forgone interest issue doesn’t arise. The gift tax concern hits interest-free or deeply discounted loans where the imputed gift exceeds $19,000 in a single year, which usually requires a large principal balance.

If You Later Decide to Forgive the Balance

Sometimes the lender decides to forgive some or all of what’s left. The tax treatment differs on each side.

For the lender, any forgiven balance is treated as a gift. If the forgiven amount plus other gifts to the same person exceeds $19,000 that year, Form 709 gets filed.⁷

For the borrower, the news is usually better. Canceled debt is ordinarily taxable income, but the IRS excludes cancellation that qualifies as a gift. Because a family member forgiving a loan almost always meets the definition of a gift, the borrower typically doesn’t owe income tax on the forgiven amount.⁸

Where families run into trouble is forgiving loans gradually, year after year, without any documentation. The IRS can look at a pattern of systematic forgiveness and decide the whole arrangement was a gift from the start, which would mean the lender owes gift tax on the entire original principal rather than the annual forgiven pieces. If you plan to forgive over time, document each forgiveness event separately and keep the annual amounts within the exclusion where possible.

When to Bring in a Professional

A simple family loan with straightforward terms doesn’t necessarily need a lawyer. A well-drafted promissory note template, the correct AFR, and a traceable transfer cover most situations. For loans above $100,000 or loans secured by real estate, an attorney can draft or review the documents for roughly $200 to $600 depending on complexity and location. That’s small insurance against a mistake that triggers thousands in unexpected taxes or leaves the lender holding an unenforceable note.

A tax professional is worth a call if either party is unsure how to report imputed interest, whether to file Form 709, or how the $100,000 exception applies to their facts. The imputed interest calculation on a below-market demand loan is tedious enough that errors are common, and the consequences are real.

1
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
2
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
3
GovInfo. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
4
Internal Revenue Service. Publication 936 – Home Mortgage Interest Deduction
5
Internal Revenue Service. Publication 550 – Investment Income and Expenses
6
Internal Revenue Service. About Form 1099-INT, Interest Income
7
Internal Revenue Service. What’s New – Estate and Gift Tax
8
Internal Revenue Service. Publication 4681 – Canceled Debts, Foreclosures, Repossessions, and Abandonments