What Is a Family Loan? AFR Rules, Gift Tax, and Reporting

A family loan works under IRS rules only if you treat it like a real loan: put it in writing, charge at least the minimum federal interest rate, collect payments on a schedule, and report the interest as income. Do that, and the money you lend a relative stays a loan. Skip those steps, and the IRS can recharacterize part or all of the transfer as a gift, with tax consequences neither side expected.

Loan or Gift? Why the Distinction Drives Everything

A loan creates a debtor-creditor relationship: the borrower owes the money back, and the lender can enforce that obligation. A gift never needs to be returned and can trigger gift tax rules. When the IRS or a court examines a family transfer, it asks whether the lender genuinely expected repayment and would enforce the debt if payments stopped.

The Tax Court has identified factors that separate the two. The more of these you can point to, the safer the loan characterization:¹

A signed promissory note or written loan agreement
Interest actually charged and collected
Collateral pledged by the borrower
A fixed maturity date
A record of payments made and tracked
A realistic ability to repay given the borrower’s finances
Consistent tax reporting by both parties

Missing a factor or two won’t automatically sink the loan. The more boxes left unchecked, the easier it becomes for the IRS to call the transfer a completed gift and assess tax accordingly.

The Minimum Interest Rate You Have to Charge

Under Internal Revenue Code Section 7872, a family loan carrying below-market interest gets split for tax purposes into a loan and a gift. The gap between what you charged and what you should have charged — the “forgone interest” — is treated as though you gave that amount to the borrower and the borrower handed it back as interest.¹ That fiction produces real tax on both sides.

The floor rate is the Applicable Federal Rate (AFR), and it varies by loan length. Section 1274(d) sets three tiers:²

Short-term for loans of three years or less
Mid-term for loans over three years and up to nine
Long-term for loans over nine years

Treasury publishes the AFRs monthly in a revenue ruling. For a term loan, the rate in effect on the day you sign locks in for the life of the note. For a demand loan with no fixed payoff date, the rate floats and gets recalculated each period. As a benchmark, the October 2025 monthly-compounding rates were 3.74% short-term, 3.80% mid-term, and 4.64% long-term. Your loan’s rate will depend on the month you close.¹

When Small Loans Escape the Rules

The tax code carves out two exceptions that spare a lot of ordinary family lending from the imputed-interest machinery.

Under $10,000

Section 7872 does not apply to a gift loan directly between individuals as long as the total outstanding balance between them stays at or below $10,000. Lend a sibling $8,000 interest-free and the IRS imputes nothing. This carve-out disappears if the borrower uses the money to buy or carry income-producing assets like stocks or a rental property.¹

Under $100,000

For gift loans with a total outstanding balance at or below $100,000, the imputed interest the lender must recognize in a given year is capped at the borrower’s net investment income for that year. If the borrower’s net investment income is $1,000 or less, it counts as zero, and no interest is imputed at all.³ The cap disappears once outstanding loans between the same two people cross $100,000, and it doesn’t apply if a principal purpose of the arrangement is tax avoidance.

Gift Tax When You Charge Too Little

Imputed interest on a below-market family loan is treated as a gift from lender to borrower. For 2026, you can give any one person up to $19,000 in a year without any gift tax consequences under the annual exclusion. A married couple electing gift-splitting can double that to $38,000.⁴ On most family loans, the imputed interest falls well below that line and no gift tax is owed.

If the forgone interest plus any other gifts to the same person in the same year exceeds $19,000, the lender has to file Form 709, the federal gift tax return. Filing doesn’t mean paying tax. The excess reduces your lifetime gift and estate exemption, which for 2026 is $15,000,000 per person.⁴ Few people actually owe gift tax, but the reporting requirement catches many lenders off guard.

How Both Sides Report the Interest

The Lender

Interest you receive on a family loan is taxable income, whether the borrower actually pays it or the IRS imputes it. Report it on your federal return just as you would bank interest. If the borrower pays you $10 or more in interest during the year, Form 1099-INT reporting can technically apply, though individual-to-individual loans rarely produce that filing in practice.⁵ The tax is owed regardless.

The Borrower

Whether the borrower can deduct the interest depends on what the loan paid for. Personal interest — money used to pay off credit cards, buy a car, or cover living expenses — is not deductible, no matter who the lender is.⁶

The main exception is a home purchase. If the loan is secured by the borrower’s main home or second home and the debt instrument is properly recorded under state or local law, the borrower can deduct the interest as qualified residence interest, the same deduction available for a conventional mortgage. The borrower must itemize on Schedule A, and both parties must genuinely intend the loan to be repaid.⁷ Interest on loans used for investment or business purposes may be deductible under separate rules with their own limits.

Forgiving the Loan Later

Canceling a family loan has consequences on both sides, and this is where families often stumble. The borrower generally has to report the forgiven balance as ordinary income.⁸ Forgive a $50,000 balance and your relative could owe income tax on that $50,000, a surprise that often overshadows the gesture.

The lender is treated as making a gift equal to the outstanding balance. If that amount exceeds the $19,000 annual exclusion, you file Form 709 and the excess reduces your lifetime exemption.⁴ Some families work around both problems by forgiving $19,000 a year (or $38,000 with gift-splitting) until the balance is gone, staying inside the annual exclusion each year and sparing the borrower a lump-sum income hit.

Certain exclusions can reduce the borrower’s cancellation-of-debt income. The two most common are insolvency (liabilities exceed assets at the time of forgiveness) and cancellation inside a Title 11 bankruptcy case. Claiming either requires filing Form 982 with the borrower’s return.⁸

When the Borrower Never Pays You Back

If a family loan goes bad and you’ve exhausted collection efforts, you may claim a nonbusiness bad debt deduction. It’s reported as a short-term capital loss regardless of how long the loan was outstanding.⁹

Two catches matter. The debt must be completely worthless — a partially unpaid family loan doesn’t qualify. And the IRS will want proof a genuine debtor-creditor relationship existed, which sends you right back to the written note, the AFR interest rate, and documented collection efforts. You report the loss on Form 8949, entering your basis in the debt (usually the outstanding principal) and zero as proceeds. A detailed statement identifying the borrower, your relationship, your collection efforts, and why you consider the debt worthless has to accompany the return.¹⁰

As a short-term capital loss, the deduction faces the capital loss limits. It offsets capital gains dollar for dollar, but only $3,000 of net capital losses can be applied against ordinary income each year, with the rest carried forward. Without a paper trail, the IRS will treat the transfer as a gift, and gifts generate no deduction at all.

Putting the Agreement in Writing

A written promissory note is the foundation of a defensible family loan. Before drafting, both sides should settle on:

Full legal names and addresses of lender and borrower
The exact principal amount
The interest rate, at least the AFR for the loan’s term based on the revenue ruling in effect on the closing date
A payment schedule with specific due dates
A maturity date for repaying the remaining balance in full
Any collateral securing the loan
Default terms, including late fees or acceleration of the balance

If the loan is secured by real property, the mortgage or deed of trust should be recorded with the local county recorder’s office. Recording establishes lien priority and lets the borrower take the qualified residence interest deduction.⁷

Both parties should sign the note, and notarizing the signatures adds authentication that helps if the document is ever challenged. Move the funds through a traceable channel — a bank wire, cashier’s check, or electronic transfer visible on both parties’ statements. Cash transfers are invisible, and invisible transfers are what the IRS treats as gifts. The lender should keep a payment ledger tracking every installment and splitting each one between principal and interest. A simple spreadsheet works. That ledger supports your interest income reporting and shows the IRS the loan is real and being enforced.

The IRS generally expects you to keep records backing up items on your return for at least three years after filing.¹¹ For a family loan, that clock doesn’t start until the loan is fully repaid or written off and you file the return covering that final year. Hold the promissory note, payment records, and bank statements for at least three years past that last return.

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
Office of the Law Revision Counsel. 26 U.S. Code 7872 – Treatment of Loans With Below-Market Interest Rates
4
Internal Revenue Service. What’s New – Estate and Gift Tax
5
Internal Revenue Service. About Form 1099-INT, Interest Income
6
Office of the Law Revision Counsel. 26 U.S. Code 163 – Interest
7
Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction
8
Internal Revenue Service. Topic No. 431, Canceled Debt – Is It Taxable or Not?
9
Office of the Law Revision Counsel. 26 U.S. Code 166 – Bad Debts
10
Internal Revenue Service. Topic No. 453, Bad Debt Deduction
11
Internal Revenue Service. How Long Should I Keep Records