Lending money to a family member feels like the right thing to do — until it creates a tax liability you didn’t see coming, a relationship you can’t repair, or an IRS audit that makes Thanksgiving permanently uncomfortable. The reality is that the IRS has detailed rules about loans between family members, and ignoring them doesn’t make those rules disappear. It makes the consequences worse.
Whether you’re a parent helping with a down payment, a sibling floating someone through a rough patch, or a grandparent funding a grandchild’s first business, here’s what you actually need to know in 2025.
The IRS Doesn’t Care That It’s Family
The single most important concept to understand is that the IRS treats intra-family loans like any other financial transaction — provided they actually look like loans. If your arrangement lacks documentation, a stated interest rate, and a repayment schedule, the IRS will reclassify it as a gift. And gifts have their own tax consequences that most people don’t anticipate.
In 2025, the annual gift tax exclusion is $19,000 per recipient. If you “lend” your daughter $80,000 with no promissory note, no interest, and no repayment plan, the IRS can treat the entire amount as a gift. The first $19,000 is excluded, but the remaining $61,000 counts against your lifetime estate and gift tax exemption ($13.99 million in 2025). You won’t owe gift tax unless you’ve exhausted that lifetime exemption, but you will need to file IRS Form 709 — and most people don’t, which is how problems start.
Applicable Federal Rates: The Floor You Can’t Ignore
If you do structure the arrangement as a legitimate loan, you must charge interest at or above the IRS’s Applicable Federal Rate (AFR). These rates are published monthly and vary by loan term:
- Short-term (≤ 3 years): Applies to smaller, shorter loans — often used for bridge funding.
- Mid-term (3–9 years): Common for family loans tied to education or vehicle purchases.
- Long-term (> 9 years): Relevant for real estate assistance or business capitalization.
As of early 2025, AFRs hover roughly between 4% and 5% depending on the term and compounding method. Check IRS Revenue Rulings each month for the exact figures. If you charge less than the AFR — or charge nothing at all — the IRS imputes “phantom interest.” This means you, the lender, owe income tax on interest you never actually received. Read that again. You can owe tax on money that never hit your bank account.
The Lender’s Tax Obligations
Interest income you receive (or that the IRS imputes) on a family loan is reported as ordinary income on your tax return. It’s taxed at your marginal rate, not at the preferential capital gains rate. For high-income lenders, this can mean a federal rate of 32% to 37% on that interest income.
Below-market loan rules (IRC Section 7872)
Section 7872 of the Internal Revenue Code specifically addresses below-market loans. For loans exceeding $10,000, the IRS will impute interest at the AFR if you charge less. There’s a narrow exception: if the total outstanding loans between you and the borrower are $10,000 or less, imputed interest rules generally don’t apply. For loans between $10,001 and $100,000, the imputed interest is limited to the borrower’s net investment income for the year — but if that investment income exceeds $1,000, the full imputed amount applies. Above $100,000, there is no cap. The imputed interest is treated as a deemed gift from lender to borrower and simultaneously as deemed interest income to the lender. You get taxed twice on the same phantom money — once as a gift, once as income.
The Borrower’s Side: When Interest Becomes Deductible
For the family member receiving the loan, the principal is never taxable income. But the interest they pay may — or may not — be deductible, depending entirely on how the funds are used:
- Personal use (car, vacation, debt consolidation): Interest is not deductible. Period.
- Home acquisition: If the loan is secured by the borrower’s primary or secondary residence and properly documented with a recorded mortgage or deed of trust, the interest may qualify as deductible mortgage interest under IRC Section 163(h). But an unsecured family loan used to buy a home does not qualify for the mortgage interest deduction — even if the borrower is making payments faithfully.
- Business or investment purposes: Interest paid on funds used to generate taxable income is generally deductible as investment interest expense (subject to the net investment income limitation) or as a business expense.
The borrower needs to maintain meticulous records tracing how the loan proceeds were used. Commingling funds in a personal checking account destroys the paper trail and the deduction.
Documentation That Actually Protects You
A legitimate intra-family loan needs a written promissory note that includes, at minimum:
- The principal amount and date of the loan
- The interest rate (at or above the AFR for the month of origination)
- A defined repayment schedule with specific due dates
- Consequences of default
- Signatures of both parties
Payments should be made by check or electronic transfer — never cash — so there’s a verifiable record. If the borrower misses payments and you don’t enforce the terms, the IRS can retroactively reclassify the entire arrangement as a gift. Good intentions and verbal promises carry zero weight in an audit.
When Loans Go Bad: The Bad Debt Deduction
If the borrower defaults and you can’t collect, you may be able to claim a nonbusiness bad debt deduction under IRC Section 166(d). This is treated as a short-term capital loss — deductible against capital gains, with up to $3,000 per year offsetting ordinary income thereafter. But the bar is high. You must prove the loan was a genuine debt (not a gift in disguise), that you made reasonable efforts to collect, and that the debt is truly worthless. Without that promissory note and a documented collection effort, this deduction evaporates.
Estate Planning Implications Most People Miss
Outstanding family loans are included in your taxable estate when you die. If you’ve lent $500,000 to your son and he still owes $300,000 at your death, that $300,000 is an estate asset. Your estate owes tax on it, and your son still owes the money — now to your estate or its beneficiaries. Alternatively, if you forgive the loan in your will, the forgiven amount is treated as a bequest. Either way, failing to plan for this creates conflict among heirs and potential estate tax exposure.
Some families use intentional loan forgiveness as a gifting strategy — forgiving $19,000 per year (the 2025 annual exclusion) to gradually reduce the outstanding balance without gift tax consequences. This is legitimate if the original loan was properly documented, but it requires disciplined annual execution and updated records.
What You Should Do This Week
If you currently have an outstanding family loan — in either direction — take these steps immediately. First, look up the AFR that was in effect when the loan was made and confirm your interest rate meets or exceeds it. Second, if there’s no written promissory note, create one now; while retroactive documentation isn’t as strong as a note signed at origination, it’s vastly better than nothing. Third, ensure all payments are being made and received through traceable channels. Fourth, talk to a CPA or tax attorney about whether Form 709 needs to be filed for any prior year. The penalty for failing to file a gift tax return has no statute of limitations — meaning the IRS can come knocking at any time. Finally, if you’re considering a new family loan, get the paperwork right before the money changes hands. The cost of a properly drafted promissory note is trivial compared to the tax liability, family conflict, and audit exposure you’ll face without one.
Disclaimer: The information provided in this article is for informational purposes only and should not be considered financial or legal advice. Laws and lending criteria vary significantly between states. We always recommend consulting with a qualified real estate attorney and financial advisor before entering into a property purchase or financial arrangement with another party.
