A loan to a relative only holds up as a loan in the eyes of the IRS if it looks and behaves like one. That means intra-family loans need a signed promissory note, an interest rate at or above the Applicable Federal Rate for the month the money changes hands, a real repayment schedule, and consistent follow-through on both sides. Miss any of those pieces and the IRS can recharacterize the whole transfer as a gift, with gift tax, penalties, and interest running back to the original transfer date.
What Makes the Loan “Bona Fide”
The IRS starts from a presumption that money moving between relatives is a gift. The lender carries the burden of showing otherwise, and two things do most of the work: a genuine intent to collect, and a borrower who can realistically repay.
Ability to repay is measured at the time of the transfer, not years later. A $200,000 loan to an adult child earning $30,000 with no assets will fail the sniff test on the math alone. A borrower who can service the debt from current income and assets makes the arrangement much easier to defend.
Intent shows up in behavior. The lender needs to act like someone who expects the money back: written reminders when payments slip, formal changes to terms when circumstances change, and a paper trail that shows the debt is being tracked. Quietly letting payments slide for years is the fastest way to lose bona fide status. Once the IRS decides the lender was never serious about collecting, every dollar transferred can be reclassified as a gift from day one.
The Promissory Note
A signed promissory note is what turns a family understanding into evidence. The document should contain the full legal names of both parties, the principal amount, the date the funds were transferred, the interest rate, a repayment schedule with specific due dates, and a final maturity date. Vague terms like “to be repaid when convenient” will sink the whole arrangement if the IRS looks at it.
If the loan is secured, describe the collateral in the note. For real estate, you also need a separate mortgage or deed of trust recorded with the county; the note by itself won’t do the job for a home loan (see below). For unsecured loans, the note carries all the weight, so precision matters more, not less.
Both parties sign. Notarization is not legally required for the note to be valid, but a notary stamp creates a timestamp that’s hard to challenge later. Under the federal Electronic Signatures in Global and National Commerce Act, an electronic signature has the same legal weight as ink, so remote signing works if both parties consent to transact electronically.1Office of the Law Revision Counsel. 15 U.S.C. 7001 – General Rule of Validity
Setting the Interest Rate
Every family loan needs to charge interest at or above the Applicable Federal Rate for the month it’s made. The IRS publishes AFRs monthly in three brackets:2Office of the Law Revision Counsel. 26 U.S.C. 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
- Short-term: loans with a term of three years or less
- Mid-term: loans over three years but not more than nine
- Long-term: loans over nine years
For scale, the December 2025 AFRs for annual compounding were 3.66% short-term, 3.79% mid-term, and 4.55% long-term.3Internal Revenue Service. Rev. Rul. 2025-24, Applicable Federal Rates for December 2025 These change monthly with Treasury yields, so check the current figures before finalizing the note.
Term Loans vs. Demand Loans
A term loan has a fixed maturity date, and the AFR is locked in for the life of the loan at the rate for the month the loan is made. The compounding period in your note (annual, semiannual, quarterly, monthly) must match the compounding period of the AFR you use.
A demand loan has no set end date and can be called at any time. Demand loans always use the short-term AFR, but the rate is not locked; it resets at the beginning of each semiannual period. If short-term rates rise, so does the imputed interest the lender has to report.4Internal Revenue Service. Publication 550, Investment Income and Expenses – Section: Below-Market Loans
Below-Market Loans and Imputed Interest
Charging less than the AFR, or charging nothing, doesn’t make the missing interest go away for tax purposes. The IRS calculates the gap between the AFR interest and what you actually charge and splits it into two imaginary transactions: the lender is treated as giving the forgone interest to the borrower (a gift), and the borrower is treated as paying it back (interest income to the lender). The lender owes income tax on interest that never actually arrived.5Office of the Law Revision Counsel. 26 U.S.C. 7872 – Treatment of Loans With Below-Market Interest Rates
A zero-interest loan to help a child buy a car sounds simple and generous, but it creates phantom income for the lender and a deemed gift to the borrower every year the balance is outstanding. Charging the AFR avoids all of it.
The $10,000 De Minimis Exception
If the total outstanding loans between the two of you stay at $10,000 or less, the below-market rules don’t apply to gift loans between individuals. The exception only works for demand loans, and only if the borrower isn’t using the money to buy or carry income-producing assets like stocks or a rental. Term loans don’t qualify at any size.4Internal Revenue Service. Publication 550, Investment Income and Expenses – Section: Below-Market Loans
The $100,000 Net Investment Income Cap
For gift loans between individuals with a total balance of $100,000 or less, the imputed interest the lender has to report is capped at the borrower’s net investment income for the year. If that net investment income is $1,000 or less, it’s treated as zero, and the lender reports nothing. Once the total outstanding balance between the two of you crosses $100,000, this cap disappears and the full imputed interest rules apply.5Office of the Law Revision Counsel. 26 U.S.C. 7872 – Treatment of Loans With Below-Market Interest Rates
Reporting the Interest
Interest earned on a family loan is taxable income and gets reported on Schedule B of Form 1040, just like bank interest.6Internal Revenue Service. Instructions for Schedule B (Form 1040) – Section: Part I, Interest This covers both interest actually received and imputed interest from a below-market loan.
Keep an amortization schedule from day one. Each payment splits into principal (not taxable to the lender) and interest (taxable), and you need that split at tax time. A spreadsheet is fine; the point is to track every payment and allocate it correctly.
When the Loan Funds a Home Purchase
Financing a home is one of the most common reasons families formalize a loan, and done right, the borrower can deduct the mortgage interest on Schedule A the same as with a bank mortgage. The IRS requirements catch many families off guard.
The loan has to be a secured debt on a qualified home. That means the borrower signs a mortgage or deed of trust giving the lender a security interest in the property, and that document has to be recorded with the county recorder or otherwise perfected under state law. A promissory note without a recorded lien will not qualify the borrower for the deduction.7Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction
The borrower also has to report the lender’s name, address, and taxpayer identification number on Schedule A. Exchanging a Form W-9 handles this cleanly. Missing the lender’s TIN can bring a $50 penalty. The interest deduction is capped at interest on the first $750,000 of mortgage debt ($375,000 if married filing separately) for loans originated after December 15, 2017.7Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction
Forgiving All or Part of the Loan
A lender can cancel any portion of an outstanding family loan, but forgiveness is a wealth transfer, and if the forgiven amount in a year exceeds the annual gift tax exclusion, the lender has to file Form 709.
For 2026, the annual gift tax exclusion is $19,000 per recipient. A lender can forgive up to that much per borrower per year without filing a return. Married lenders who elect gift splitting can combine their exclusions to reach $38,000 per borrower. Anything above the exclusion reduces the lender’s lifetime gift and estate tax exemption, which is $15,000,000 for 2026.8Internal Revenue Service. What’s New – Estate and Gift Tax
Some families forgive a loan in annual increments sized to the exclusion, effectively unwinding the debt over several years without touching the lifetime exemption. This works only if the original loan was genuinely bona fide. If the facts suggest the plan was always to forgive the debt, the IRS may treat the original transfer as a gift.
On the borrower’s side, forgiven family debt is not treated as cancellation-of-debt income. When a relative forgives out of generosity, the IRS treats the forgiveness as a gift, and gifts are excluded from gross income.9Office of the Law Revision Counsel. 26 U.S.C. 102 – Gifts and Inheritances The borrower owes no income tax on the forgiven balance.10Office of the Law Revision Counsel. 26 U.S.C. 108 – Income From Discharge of Indebtedness
Document the forgiveness in a written release that references the original note, states the amount forgiven, and carries the date. Both parties keep copies. After the debt is canceled, the lender stops reporting interest income from it, and heirs or executors won’t later mistake the note for an outstanding asset of the estate.
If the Borrower Stops Paying
Silence in the face of missed payments is the single most damaging thing a family lender can do. Non-enforcement is the factor most likely to trigger reclassification of the whole loan as a gift, potentially back to the original transfer date, along with gift tax, interest, and penalties.
You don’t need to sue immediately. You do need a written record that you noticed the default and responded. That can be a formal demand letter, a written restructuring of the payment schedule, or a signed acknowledgment that payments are behind. Anything that shows you treated the debt as a debt helps preserve bona fide status.
Bad Debt Deduction
If the borrower genuinely cannot pay and the debt becomes completely worthless, the lender may be able to claim a nonbusiness bad debt deduction. It’s reported as a short-term capital loss on Form 8949, regardless of how long the loan was outstanding.11Office of the Law Revision Counsel. 26 U.S.C. 166 – Bad Debts The loss is then subject to the usual capital loss limits: $3,000 per year against ordinary income, with the remainder carrying forward.
The bar is high. The debt has to be totally worthless; partial worthlessness doesn’t cut it for a family loan. The IRS also requires a statement attached to the return describing the debt, the borrower, the relationship, your collection efforts, and why you concluded the debt is worthless.12Internal Revenue Service. Topic No. 453, Bad Debt Deduction If you lent knowing the borrower might not repay, the IRS treats the transfer as a gift from the start, and there is no deduction. This is the payoff for good documentation up front: the stronger the original paper trail and the more consistent the collection behavior, the more defensible a bad debt claim if the loan eventually goes bad.