To loan money to a family member legally, put the terms in a written promissory note, charge at least the IRS’s Applicable Federal Rate, transfer the funds in a way that leaves a paper trail, and keep a ledger of every payment. Skip any of those, and the IRS can reclassify the loan as a gift, and you may have no way to enforce repayment if the borrower stops paying.
The formality feels awkward inside a family. It’s also what protects both sides.
Settle the Terms Before Any Money Moves
Start with the principal — the exact dollar amount you’re lending — and a repayment schedule with specific due dates and specific payment amounts. That can be monthly or quarterly installments, a single lump sum on a future date, or smaller payments leading up to a balloon payment at the end. Vague understandings are what get families into trouble later.
Decide whether the loan is secured or unsecured. An unsecured loan rests on the borrower’s promise. A secured loan is backed by a specific asset, like a vehicle or piece of equipment, that you can claim if the borrower defaults. If you go the secured route, identify the collateral in the loan document. To make that security interest enforceable against other creditors, you generally need to file a financing statement or record a lien through your state’s motor vehicle or property recording office. Filing procedures and fees vary by state, so confirm the process with your local agency before assuming you’re protected.
Charge at Least the Applicable Federal Rate
Charging interest on a family loan feels uncomfortable, but the IRS expects it. If you charge nothing or too little, the agency calculates what you should have charged and treats that phantom amount as taxable interest income to you.
The floor is the Applicable Federal Rate (AFR), published monthly in three tiers based on how long the loan runs:
- Short-term (three years or less): 3.56% as of February 2026
- Mid-term (over three years, up to nine): 3.86%
- Long-term (over nine years): 4.70%
Those figures come from the February 2026 revenue ruling, and the IRS updates them every month.{CITE1} The statutory breakpoints between short-, mid-, and long-term come from the Internal Revenue Code.{CITE2} Check the current month’s rates before finalizing the agreement, because locking in last month’s rate when this month’s is higher creates the same imputed-interest problem as charging nothing.
Two exceptions ease the burden on smaller loans. If the total outstanding between you and the borrower is $10,000 or less on any given day, the imputed interest rules don’t apply.{CITE3} For loans between $10,001 and $100,000, the interest the IRS can impute in a given year is capped at the borrower’s net investment income for that year, and if that net investment income is $1,000 or less, it’s treated as zero, meaning no imputed interest at all.{CITE4} Neither exception applies if a principal purpose of the interest arrangement is avoiding federal tax.{CITE5}
The AFR is a floor, not a target. Every state also sets a ceiling through usury laws. Caps vary widely, and violating them can void the loan or trigger penalties. If your rate goes materially above the AFR, confirm it falls below your state’s legal maximum.
Draft and Sign a Promissory Note
Once the terms are settled, put them in a promissory note. This is the borrower’s written promise to repay a specific amount under specific conditions, and it’s what makes the loan legally enforceable. Include:
- Full legal names and addresses of lender and borrower
- Principal amount
- Interest rate and how it’s calculated (simple or compound, annual or monthly)
- Repayment schedule with due dates, payment amounts, and the final payoff date
- Late payment terms, including any grace period and late fee
- Description of any collateral
- Default provisions defining what counts as default and what happens next
Templates are available through legal form websites and document preparation services. Read every clause before filling one in; generic templates sometimes include provisions that don’t match your situation or that conflict with your state’s laws. For loans above $10,000 or loans secured by real property, having an attorney review the note is worth the cost.
Both parties sign and date the note. Federal law recognizes electronic signatures as legally valid for contracts, so a reputable e-signature platform works if you’re in different locations.{CITE6} Some states have specific rules for certain secured transactions, so e-signatures are safest on standard unsecured notes.
Notarization isn’t legally required in most situations, but it’s cheap protection. A notary verifies each signer’s identity through government-issued photo ID and witnesses the signatures, which makes it much harder for someone to later claim they didn’t sign or were pressured. Fees for a standard signature acknowledgment typically run between $5 and $25. If the loan ever ends up in court, a notarized document carries more weight than one without.
Each party should keep a signed original or certified copy. Store yours with your other important financial documents.
Transfer the Funds and Keep a Ledger
Move the money in a way that creates a paper trail: a bank wire, ACH transfer, or personal check. Avoid cash. If the IRS ever questions whether this was a loan or a gift, a traceable transfer paired with a signed promissory note is your strongest evidence.
Then keep a payment ledger for the life of the loan. Record the date and amount of every payment, how it was received, and the remaining balance. A simple spreadsheet is fine. That log keeps both parties honest and gives you the documentation you’d need to prove the loan’s legitimacy to the IRS or to claim a bad debt deduction later.
How the IRS Treats Family Loans
Loan or Gift
The IRS draws a hard line between the two. A loan involves a genuine expectation of repayment; a gift does not. If your family loan lacks a written agreement, charges no interest, and shows no repayment history, the IRS can reclassify the entire amount as a gift.{CITE7} That isn’t just a label change — it can trigger gift tax reporting obligations and eat into your lifetime gift tax exemption.
Courts look at a consistent set of factors when deciding whether a family transfer was really a loan: a signed promissory note, a fixed repayment schedule, actual payments being made, an interest rate at or above the AFR, and the borrower’s ability to repay. The more you can show, the stronger your position. Missing pieces, especially any real repayment activity, give the IRS an opening to challenge the arrangement.
Imputed Interest
If you charge below the AFR (or nothing at all) on a loan over $10,000 and neither exception applies, the IRS imputes the difference. It calculates what you would have earned at the AFR and treats that as taxable interest income to you, even though you never received it.{CITE8} The same imputed amount can also be treated as a gift from you to the borrower, which matters for gift tax purposes.
For 2026, the annual gift tax exclusion is $19,000 per recipient.{CITE9} If imputed interest stays below that, you won’t owe gift tax or need to file a gift tax return. If it exceeds $19,000, you report the excess on Form 709. In practice, imputed interest rarely gets that high unless the loan is very large and completely interest-free.
Interest You Actually Receive
Interest the borrower pays you is taxable income. Report it on Schedule B of your Form 1040, listing the borrower’s name and the total received during the year.{CITE10} You won’t receive a 1099-INT, since the borrower isn’t a financial institution, so your own records are what you’ll use to calculate the amount. Another reason the ledger matters.
If the Borrower Stops Paying
Collection
A promissory note gives you the legal right to sue for the unpaid balance, but suing a family member is rarely anyone’s first choice. Start with a written demand letter that references the note, states the overdue amount, and sets a deadline. If that fails, mediation through a neutral third party can sometimes break a stalemate. Keep copies of every communication; they become evidence of your collection efforts.
Every state imposes a statute of limitations on enforcing a written promissory note. These typically run three to six years, though some states allow longer. Once the deadline passes, you lose the right to sue no matter how solid the note. If payments stop, don’t wait years to act.
Bad Debt Deduction
If the borrower genuinely cannot repay and you’ve exhausted reasonable collection efforts, you can claim a nonbusiness bad debt deduction. The IRS requires the debt to be totally worthless — a partial loss on a personal loan isn’t deductible.{CITE11} You also have to show you intended a loan (not a gift) at the time of the transaction, and that you took reasonable steps to collect before writing it off.
A nonbusiness bad debt is treated as a short-term capital loss and reported on Form 8949.{CITE12} That means capital loss rules apply: it offsets capital gains dollar for dollar, but you can deduct only up to $3,000 per year against ordinary income, carrying any excess forward. Your return must include a detailed statement explaining the debt, the borrower’s name, your relationship, your collection efforts, and why you determined the debt was worthless.{CITE13}
Forgiving the Loan
If you decide to forgive what’s owed, the tax consequences split between the two of you. On your side, forgiveness is treated as a gift. If the forgiven amount exceeds the $19,000 annual exclusion for 2026, you file Form 709.{CITE14}
On the borrower’s side, canceled debt is generally taxable income.{CITE15} One of the statutory exceptions covers amounts canceled as gifts, and if the IRS treats your forgiveness as a genuine gift — which it usually will when a family member voluntarily forgives a debt — the borrower owes no income tax on the forgiven amount.{CITE16} To keep the record clean, execute a written release that references the original promissory note, states you’re releasing the borrower from all remaining obligations, and is signed and dated.
Bankruptcy
If your borrower files for Chapter 7, any unsecured debt they owe you goes in with every other unsecured claim. Family members are classified as “insiders” under bankruptcy law, which creates a specific risk: the trustee can look back a full year before the filing date and claw back any payments the borrower made to you during that period if the borrower was insolvent at the time.{CITE17} For non-family creditors, the look-back window is only 90 days.
The borrower must list your loan in the bankruptcy petition; leaving it off isn’t an option. If the debt is discharged, you lose the legal right to collect. The borrower may still choose to repay voluntarily after the case closes, but you can’t pressure them. A secured loan with a properly recorded lien puts you in a stronger position, because secured creditors are paid before unsecured ones and the lien itself may survive the bankruptcy.