A bona fide loan is a transfer of money that creates a genuine debtor-creditor relationship, with a real obligation to repay, and because that obligation exists the borrowed funds are not taxable income. The label on the paperwork is not what controls the outcome. The IRS looks at whether the transaction functions like something an arm’s-length lender would recognize as a loan, and it applies the closest scrutiny to transfers between family members, between a closely held corporation and its shareholders, and between employers and employees. Get the substance right and standard debt rules apply. Get it wrong and the “loan” becomes a gift, a dividend, or wages, usually with penalties on top.
What Makes a Loan Bona Fide
Courts weigh a set of factors together rather than treating any single element as decisive. The point of each factor is the same: does the transaction look like real debt, and did the parties behave like a real creditor and a real debtor?
A Written, Enforceable Promissory Note
A signed promissory note is the starting point. It should state the principal amount, the interest rate, a fixed maturity date, and a repayment schedule. Without written documentation, the IRS has an easy argument that no real debt existed. The note also needs to be a legally enforceable contract, meaning the lender has the right to sue on default. Both sides should reflect the debt in their own financial records.
Interest at or Above the Applicable Federal Rate
The loan has to carry a reasonable rate. For transfers between related parties, the floor is the Applicable Federal Rate, which the IRS publishes monthly.1Internal Revenue Service. Applicable Federal Rates Which AFR applies depends on the loan’s term: the short-term rate covers loans of three years or less, the mid-term rate covers loans over three years through nine, and the long-term rate applies past 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 Charging less than the AFR triggers the imputed interest rules discussed below.
A Real Repayment Schedule, With Real Payments
Fixed, regular payments of principal and interest are among the strongest indicators that a loan is genuine. Vague terms like “pay it back when you can,” or repayment tied entirely to the borrower’s future ability to pay, suggest no real expectation of repayment. The most compelling proof is a documented history of the borrower actually making payments on time, backed by bank records or canceled checks.
What the lender does when a payment is missed matters as much as the original terms. A lender who shrugs off missed payments, quietly extends the maturity date, or never sends a demand letter is behaving like someone who gave a gift. The IRS routinely uses that pattern to reclassify transactions between related parties.
Collateral
Arm’s-length lenders usually require collateral proportional to the risk, and then take the formal steps to protect the pledge. For personal property, that means filing a UCC-1 financing statement identifying the debtor, the secured party, and the collateral.3Legal Information Institute. UCC Financing Statement For real estate, it means recording a mortgage or deed of trust. The absence of collateral does not automatically doom a loan, but it makes the IRS’s challenge easier, especially where the borrower’s creditworthiness is thin. Filing fees are modest, and the formality itself signals a lender who is serious about their position.
The Borrower’s Ability to Repay
A prudent lender checks whether the borrower can service the debt before writing the check. The IRS looks at the borrower’s income, existing debts, and assets at the time the loan was made. Lending a large sum to someone clearly insolvent, or to an undercapitalized entity, suggests the lender never expected repayment. Even an informal review of the borrower’s finances, memorialized in a short note or email, helps show the parties behaved like a real creditor and debtor.
Tax Treatment When the Loan Holds Up
Once a transaction qualifies as genuine debt, ordinary debt tax rules apply. The principal is not income to the borrower when received and not a deduction for the lender when advanced.
Interest Income and Interest Expense
The lender reports interest received as ordinary income. If total interest received exceeds $1,500 in a year, it goes on Schedule B of Form 1040.4Internal Revenue Service. About Schedule B (Form 1040), Interest and Ordinary Dividends The lender must also file Form 1099-INT with the IRS, and give a copy to the borrower, if interest paid reaches at least $10 during the year.5Internal Revenue Service. About Form 1099-INT, Interest Income
Whether the borrower can deduct the interest depends on how the loan proceeds were used. Interest on debt used to buy or improve a qualified residence may be deductible as mortgage interest, and interest on debt used to buy investments may be deductible as investment interest. Most personal interest, such as credit card debt, is not deductible, though for tax years 2025 through 2028 a limited deduction of up to $10,000 a year is available for interest on qualifying car loans secured by a first lien on the vehicle.6Internal Revenue Service. Topic No. 505 – Interest Expense
Below-Market Loans and Imputed Interest
When a loan charges less than the AFR, the tax code treats it as if full interest were charged anyway. Under IRC Section 7872, the IRS imputes interest on three categories of below-market loans: gift loans, compensation-related loans, and corporation-shareholder loans.7GovInfo. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates The difference between AFR interest and whatever interest the borrower actually pays is treated as if the lender transferred that amount to the borrower and the borrower paid it back as interest. The lender owes tax on the imputed interest income, and the deemed transfer to the borrower is treated as a gift, additional compensation, or a corporate distribution depending on the relationship. For demand loans, the calculation is redone each year using that year’s AFR. For term loans, it happens upfront using the AFR in effect when the loan was made.8Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
Small-Loan Exceptions
Not every interest-free family loan triggers imputed interest. Section 7872 has a $10,000 de minimis exception: if total outstanding loans between two individuals stay at or below $10,000, the imputed interest rules do not apply. A separate $10,000 de minimis rule covers compensation-related and corporation-shareholder loans.8Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
For gift loans between individuals with a total outstanding balance at or below $100,000, imputed interest income is capped at the borrower’s actual net investment income for the year, and no interest is imputed if the borrower had none. This cap disappears if one of the principal purposes of the arrangement is federal tax avoidance, and it stops applying once outstanding loans between the same two people cross $100,000.8Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
Bad Debt Deduction if the Loan Goes Unpaid
If a bona fide loan becomes genuinely uncollectible, the lender can claim a bad debt deduction under IRC Section 166, and how it works depends on whether the debt arose in the lender’s trade or business.9Office of the Law Revision Counsel. 26 USC 166 – Bad Debts
- A business bad debt is fully deductible as an ordinary loss, and partial write-offs are allowed when only part of the debt is recoverable.
- A non-business bad debt (most personal and family loans) is treated as a short-term capital loss regardless of how long the loan was outstanding. That loss offsets capital gains first, then up to $3,000 of ordinary income per year ($1,500 if married filing separately), with unused amounts carrying forward.10Internal Revenue Service. Topic No. 409, Capital Gains and Losses
Either deduction requires proving two things: the loan was bona fide, and reasonable efforts were made to collect before writing it off. A lender who never sent a demand letter or explored legal remedies will struggle to convince the IRS the debt was real and that collection was hopeless.
What Happens If the IRS Says It Wasn’t a Loan
When the IRS concludes a purported loan was not genuine debt, it reclassifies the transfer based on who the parties are. What was tax-neutral becomes taxable, often with back taxes, interest, and penalties.
Reclassified as a Gift
Between family members, a failed loan is most often reclassified as a gift. The transferor is treated as having made a donative transfer and reports it on Form 709.11Internal Revenue Service. About Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return The annual gift tax exclusion shields $19,000 per recipient for 2026, so only amounts above that threshold count against the donor’s lifetime exemption.12Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 The lifetime basic exclusion amount for 2026 is $15,000,000 per individual.13Internal Revenue Service. What’s New – Estate and Gift Tax Most donors will never owe actual gift tax, but failing to file Form 709 when required keeps the statute of limitations from starting to run on that gift, which can surface later in estate administration.
Reclassified as a Constructive Dividend
When a corporation advances money to a shareholder without the hallmarks of real debt, the IRS treats the transfer as a constructive dividend. The corporation gets no deduction. The shareholder reports the amount as income to the extent of the corporation’s accumulated earnings and profits, with any excess treated first as a tax-free return of stock basis and then as capital gain. Qualified dividends may be taxed at preferential capital gains rates, but the shareholder loses the ability to treat the funds as tax-free loan proceeds.
Reclassified as Compensation
An employer-to-employee “loan” without meaningful repayment terms gets reclassified as wages. The full amount becomes taxable compensation subject to income tax withholding and FICA (Social Security at 6.2% and Medicare at 1.45% on both sides). The employer must issue a corrected Form W-2 for the additional wages.14Internal Revenue Service. About Form W-2 C, Corrected Wage and Tax Statements The reclassified compensation is deductible to the employer, but payroll tax liability and penalties typically outweigh that benefit.
Accuracy-Related Penalty
A recharacterization often triggers the 20% accuracy-related penalty on the resulting underpayment. This penalty applies to underpayments attributable to negligence, disregard of rules, or a substantial understatement of income tax.15Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments Calling something a “loan” without any of the documentation or formalities described above is the kind of conduct that invites it. Interest on the unpaid tax also runs from the original due date, which compounds the cost when a recharacterization reaches back several years.
How to Protect the Loan Before the Money Moves
The factors are well established, so the roadmap is straightforward. Build the record before the funds change hands, not during an audit.
- Draft a signed promissory note with the principal, a stated rate at or above the current AFR for the term, a fixed maturity date, and a monthly or quarterly payment schedule.
- Charge and actually pay interest. Use the IRS’s monthly AFR publication for the correct rate, and move interest payments by check or electronic transfer so there is a paper trail.
- Stick to the schedule. If a payment is late, send a written reminder. Forgiving payments or repeatedly extending deadlines undermines the arrangement.
- Secure larger loans by filing a UCC-1 or recording a mortgage. Filing fees are small next to the protection.
- Document the borrower’s ability to repay, even informally, at the time the loan is made.
- File Form 1099-INT if interest received reaches $10 or more, and report all interest income on the lender’s return. Skipping these filings hands the IRS evidence that neither party treated the transaction as real debt.
None of these steps requires a lawyer, though consulting one is worth it for six-figure loans or complex corporation-shareholder arrangements.