A family mortgage is a private home loan between relatives, secured by the property being purchased and documented with a promissory note and a recorded mortgage or deed of trust. The IRS treats it like any other mortgage, which means the lender must charge at least the Applicable Federal Rate published for the month the loan is funded, and the paperwork has to hold up to the same scrutiny a bank loan would. Done right, the borrower skips origination fees and private mortgage insurance while still deducting the interest, and the lender earns a return on money that might otherwise sit in a savings account.
How the Arrangement Is Structured
In the standard version, one family member funds all or part of the purchase price and the borrower signs a promissory note plus a mortgage or deed of trust giving the lender a security interest in the home. The lending relative sets the term, collects monthly payments, and holds the same legal position a bank would occupy. No underwriting fees, no PMI, no bank in the middle.
A few retail banks offer a hybrid product where a relative deposits savings into an offset account that reduces the borrower’s effective rate, but the family’s money is typically locked up for the life of the loan and bank fees still apply. For most families the direct loan is the more practical choice because both sides keep control of the rate (within IRS limits), the schedule, and how to handle events like job loss or an early payoff.
The IRS Minimum Interest Rate
Federal law will not let a family disguise a gift as an interest-free loan. Any private loan charging less than the Applicable Federal Rate is treated as a “below-market loan,” and the IRS taxes the gap between what you charged and what you should have charged as if the lender had received it.1Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates That phantom interest becomes taxable income to the lender even though no money changed hands.
The AFR is published monthly and comes in three flavors by loan term: short-term for three years or less, mid-term for more than three through nine years, and long-term for anything over nine years.2Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property Since most family mortgages run 15 or 30 years, the long-term rate is the one that applies. For February 2026, the annual-compounding AFRs are 3.56% short-term, 3.86% mid-term, and 4.70% long-term.3Internal Revenue Service. Rev. Rul. 2026-3 – Applicable Federal Rates for February 2026 The rate you lock at origination applies for the life of a fixed-rate term loan, so document the applicable AFR in the promissory note itself. You can always charge more than the AFR, and many families split the difference between the AFR floor and prevailing commercial rates.
Smaller Loans That Escape the Rule
If the total you have lent a family member stays at $10,000 or less on any given day, the imputed interest rules do not apply and you can charge zero interest. That exception disappears if the borrower uses the money to buy income-producing assets like rental property or stocks.1Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
For loans between $10,001 and $100,000, the imputed interest a lender must report is capped at the borrower’s net investment income for the year, and if that figure is under $1,000 the IRS treats it as zero.4GovInfo. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates This exception rarely helps with a full home purchase but does matter for down payment assistance or renovation financing.
Gift Tax Exposure
When the note charges less than the AFR, the forgone interest is treated as a gift from lender to borrower. If the imputed gift exceeds $19,000 per recipient in 2026, the lender must file Form 709.5Internal Revenue Service. Gifts and Inheritances 1 A married couple electing gift-splitting can give up to $38,000 per recipient before filing is required.
Filing does not mean owing. The federal lifetime gift and estate tax exemption is $15,000,000 per person for 2026, so most families will never owe actual gift tax.6Internal Revenue Service. What’s New – Estate and Gift Tax But amounts above the annual exclusion still consume the lifetime figure, leaving less protection against estate tax later. Charging at least the AFR sidesteps the issue entirely.
The Documents You Need
Two documents hold a family mortgage together. Treating either as optional is the most common way these arrangements fail, because without proper paperwork the IRS can reclassify the whole transaction as a gift and the borrower loses the interest deduction.
The promissory note is the borrower’s personal promise to repay. It sets out the loan amount, interest rate, monthly payment, due date, maturity date, prepayment rights, and what constitutes a default. A reasonable late fee provision, typically 4% to 5% of the overdue installment, signals that both parties treat the arrangement as a real loan. Federal regulations cap late fees at 5% for FHA-insured loans, and most states apply similar limits to private mortgages.
The mortgage or deed of trust is what ties the loan to the property. It gives the lender a security interest and the right to foreclose if the borrower stops paying. It needs a legal description of the property (the parcel number and boundary description from the deed, not just the street address) and the full legal names of both parties as they appear on government identification. Both documents should confirm that the interest rate meets or exceeds the AFR in effect on the funding date. A real estate attorney can draft the pair for a few hundred dollars. Online templates exist, but quality varies and they may not comply with your state’s recording rules.
Recording the Mortgage
After signing and notarization, the mortgage or deed of trust must be filed with the county recorder’s office (in some states called the registrar of deeds). Recording puts other creditors on notice of the lender’s claim and satisfies the IRS requirement that the debt be “recorded or otherwise perfected” for the borrower to deduct interest.7Internal Revenue Service. Publication 936 – Home Mortgage Interest Deduction Skip this step and the borrower cannot claim the mortgage interest deduction, full stop.
Recording fees vary by county, with base fees typically ranging from under $20 to over $100, and a handful of states impose a mortgage recording tax based on the loan amount. Notary fees are modest, generally under $25 per signature. Keep the stamped copy the clerk returns with the rest of your loan file. You will need it to refinance, sell, or answer an audit.
Tax Reporting on Both Sides
What the Lender Reports
Interest received from a family mortgage is taxable income, reported on Schedule B of Form 1040 with the borrower’s name, address, and Social Security number.8Internal Revenue Service. Instructions for Schedule B (Form 1040) If the rate was below the AFR, the lender also reports the imputed interest as income even though it was never collected.9Internal Revenue Service. Publication 550 – Investment Income and Expenses
Private family lenders are not required to issue Form 1098. That form is for parties receiving mortgage interest in the course of a trade or business, which a parent lending to a child is not.10Internal Revenue Service. About Form 1098 – Mortgage Interest Statement
What the Borrower Deducts
The borrower can deduct interest paid on a family mortgage the same way they would on a bank mortgage, but only if the loan is a secured debt recorded or otherwise perfected under state law.7Internal Revenue Service. Publication 936 – Home Mortgage Interest Deduction An unrecorded handshake loan will not qualify no matter how faithfully the payments are made. The borrower must itemize on Schedule A, and because no 1098 will arrive, they report the interest directly along with the lender’s name, address, and taxpayer identification number.
Meticulous records matter on both sides. Every payment should be logged with the date, amount, and principal-versus-interest split. The IRS expects the same documentation from a family mortgage that it would from a bank loan, and using a third-party loan servicer to send statements and track amortization creates a paper trail that looks identical to a conventional mortgage.
Default and Forgiveness
Lending is easy. Collecting when a borrower stops paying is where relationships fracture, which is why the default terms belong in the original documents.
If the mortgage was properly recorded, the lender holds the same rights a bank would, including the right to foreclose. Federal rules bar foreclosure proceedings from starting until payments are more than 120 days past due, and the process from there follows state law. Most families never reach that point, but having the mechanism in writing motivates both sides to negotiate a payment adjustment first.
If the lender decides to forgive part or all of the balance, the tax treatment turns on the circumstances. When a family member forgives a loan as a gift, the borrower generally owes no income tax on the canceled amount because gifts are excluded from gross income.11Internal Revenue Service. Publication 4681 – Canceled Debts, Foreclosures, Repossessions, and Abandonments The forgiven balance does count as a gift from the lender for gift tax purposes, though. A $200,000 forgiveness in a single year blows past the $19,000 annual exclusion and eats into the lender’s lifetime exemption. Some families forgive a large balance in annual increments that stay within the exclusion, which spreads the exposure but requires planning.
What Happens If the Lender Dies
The promissory note does not disappear when the lender passes away. It is an asset of the estate, included in the gross estate at fair market value, which is generally the unpaid principal plus accrued interest through the date of death. The executor can argue for a lower valuation if the note’s rate is below current market rates or the borrower genuinely cannot pay, but the burden falls on the estate.
The note passes to whoever inherits it, by will, trust, or intestacy. The new holder steps into the lender’s shoes and can continue collecting, modify the terms, or forgive the balance under the same gift tax rules. Naming a successor note holder in the original documents, or directing the note into a trust, spares the borrower from having to wait out probate for any adjustment they may urgently need.
For most families, the $15,000,000 lifetime exemption absorbs the note without any actual estate tax owed.6Internal Revenue Service. What’s New – Estate and Gift Tax For high-net-worth lenders, a large outstanding balance stacks on top of everything else in the estate, and forgiving the loan during life (as a gift consuming the same exemption) may produce a better result than leaving it to be taxed at full face value.