IRS Guidelines for Intra-Family Loans: AFR, Reporting, and Forgiveness

The IRS guidelines for intra-family loans come down to a single test: does the arrangement behave like a real loan, or does it look like a gift dressed up in loan language? To pass that test in 2026, you need a written promissory note, an interest rate at or above the Applicable Federal Rate for the month you sign, an actual repayment schedule that both sides honor, and consistent reporting of the interest the lender receives. Miss any of those pieces and the IRS can recharacterize the transfer, creating gift tax exposure for the lender and unwinding any interest deduction the borrower was counting on. Because the lifetime gift and estate tax exemption sits at $15,000,000 per person for 2026, a mishandled family loan can quietly eat into wealth you meant to pass on later.

What Makes a Family Loan a Loan and Not a Gift

The IRS looks at substance, not labels. A legitimate intra-family loan needs a written promissory note stating the principal, the interest rate, a maturity date, and a specific repayment schedule with payment amounts and due dates. That document is the single most important piece of evidence separating a loan from a gift.

The note should include the same clauses a commercial lender would insist on: what counts as default, what happens on default, and the lender’s right to demand full repayment if payments stop. They may feel awkward between relatives, but they show the arrangement is enforceable. Without them, an auditor can argue the lender never intended to collect.

Paper alone won’t carry the day. The borrower has to make payments on schedule, and the lender has to accept and deposit them. A record of consistent, on-time payments is the strongest evidence in an audit. Skipping payments, accepting late ones without consequence, or quietly waiving installments all erode the loan’s legitimacy. If a stranger wouldn’t get away with it, a relative shouldn’t either.

When the loan is secured by property, the security interest has to be recorded under state law. For real estate, that means recording a mortgage or deed of trust with the county. For other collateral, it usually means filing a financing statement. Recording protects the lender’s priority and creates a public record that reinforces the commercial nature of the deal.

The Applicable Federal Rate You Must Charge

Every intra-family loan must charge interest at or above the Applicable Federal Rate, the minimum rate the IRS sets for private loans. The AFR has three tiers based on the loan’s term:

Short-term: three years or less.
Mid-term: longer than three years but not more than nine years.
Long-term: longer than nine years.

The tiers are defined in the Internal Revenue Code, and the IRS publishes updated rates for each tier every month in a Revenue Ruling.¹ Current rates live on the Applicable Federal Rates page at irs.gov. For reference, the rates published in April 2026 (Rev. Rul. 2026-7) were 3.59% short-term, 3.82% mid-term, and 4.62% long-term, assuming annual compounding. The rates change each month, so always check the ruling for the month you sign.

For a fixed-term loan, the AFR on the date you sign the note locks in for the life of the loan. If market rates rise or fall later, that original rate stays valid. This is a major advantage of using a definite maturity date rather than an open-ended arrangement.

Demand loans work differently. Because they have no fixed maturity and can be called at any time, they use the short-term AFR, and that rate floats with each period’s published rate.² The tax math becomes less predictable year to year. Most families are better off with a fixed-term note.

One detail catches many people out: the AFR is published for four compounding frequencies (annual, semiannual, quarterly, and monthly), and the required minimum depends on which compounding period the promissory note specifies. Monthly compounding carries a slightly lower stated rate than annual compounding for the same tier, because more frequent compounding produces the same effective yield at a lower nominal rate. Match the note to the AFR that fits its stated compounding.

What Happens When You Charge Too Little

A loan below the AFR is classified as a below-market loan, and the fix isn’t just going forward. The IRS retroactively treats the missing interest as though it had been paid, creating a two-part tax fiction that hits both sides.²

First, the lender is treated as having made a gift to the borrower equal to the difference between the interest that should have been charged at the AFR and whatever was actually charged. That’s the forgone interest. Second, the borrower is treated as having paid that same amount back to the lender as interest. The lender now owes income tax on interest they never received, and they’ve also made a taxable gift they never planned.

The gift piece runs through the normal gift tax framework. For 2026, each person can give up to $19,000 per recipient without any gift tax reporting.³ If the imputed gift stays under that threshold, no Form 709 is required. Above it, the lender must file Form 709 for the year the gift occurred, even if no tax is owed.⁴ The excess reduces the lender’s $15,000,000 lifetime exemption, cutting the wealth they can eventually pass on tax-free.

These rules apply automatically. They don’t depend on whether the lender meant to make a gift or simply forgot to check the AFR tables. Charging at or above the AFR is the only reliable way to avoid the whole chain.

Exceptions for Smaller Loans

The tax code carves out two exceptions that spare smaller loans, but each comes with limits.

The first is a $10,000 de minimis exception. If the total outstanding balance of all loans between the same two people stays at or below $10,000, the imputed interest rules don’t apply.² The catch: if the borrower uses the proceeds to buy income-producing assets like stocks or rental property, the exception disappears. For most families lending money for a down payment or business startup, this exception is too small and too fragile to rely on.

The second exception covers loans with an aggregate balance between $10,001 and $100,000 between the same two people. Here, the imputed interest the lender must report is capped at the borrower’s net investment income for the year.² Net investment income includes dividends, interest, short-term capital gains, and similar returns. If the borrower’s net investment income is $1,000 or less for the year, it’s treated as zero, so no interest is imputed to the lender. Once the aggregate balance crosses $100,000, the cap disappears and full imputation kicks in.

Even when one of these exceptions eliminates the income tax side, the gift tax analysis may still apply. For any loan you’d hate to lose in an audit, charge the AFR and document it.

What the Lender Has to Report Each Year

Signing the note is only the start. The lender must report all interest received from the borrower as income on their federal tax return, whatever the amount. For seller-financed home loans specifically, the lender must also report the borrower’s name, address, and Social Security number on Schedule B, regardless of the interest amount.⁵

If the lender forgives part of the loan or the imputed gift from a below-market rate exceeds $19,000 in a calendar year, Form 709 is due by April 15 of the following year.⁴ The return is required even when the gift is fully absorbed by the lifetime exemption and no tax is due. It documents how much of that exemption has been used, which matters for estate planning later.

Both parties should keep a detailed ledger of every payment: date, amount, and how much went to principal versus interest. The lender should retain the original signed note and any amendments. If the IRS questions the arrangement years later, that paper trail is what separates a surviving loan from one that gets recharacterized as a gift.

When the Borrower Can Deduct the Interest

Interest paid on a family loan isn’t automatically deductible. It depends on what the loan was used for and how it was structured. The most common deductible scenario is a loan used to buy, build, or substantially improve the borrower’s home, properly secured by that home.

To qualify for the mortgage interest deduction, the loan must meet three requirements: the borrower has to sign a mortgage or deed of trust making the home collateral, the instrument must allow the home to satisfy the debt on default, and the security interest must be recorded under state or local law.⁶ A handshake understanding that the house is “backing” the loan won’t work. Both sides must intend the loan to be repaid.

For loans taken out after December 15, 2017, total mortgage debt eligible for the interest deduction is capped at $750,000 ($375,000 if married filing separately).⁶ The borrower has to itemize on Schedule A to claim it. If the proceeds went to something other than the home securing the loan, the interest generally isn’t deductible as mortgage interest.

If the Borrower Can’t Pay

When a family loan goes bad and the borrower genuinely cannot repay, the lender may be able to claim a nonbusiness bad debt deduction. This is where careful documentation pays off, because the IRS is deeply skeptical of family bad debt claims.

The deduction is available only if the lender can show the arrangement was always intended as a loan, not a gift. Money lent with the understanding it might not be repaid is a gift, and gifts are never deductible.⁷ That’s exactly why the written note, the payment history, and the enforcement clauses matter. They fix intent at the time the loan was made, not after it soured.

The lender also has to show the debt is truly worthless by taking reasonable steps to collect. A lawsuit isn’t required if a judgment would be uncollectible anyway, but the lender needs evidence of collection efforts: demand letters, attempts to negotiate a revised plan, or documentation of the borrower’s inability to pay.⁷

A nonbusiness bad debt is treated as a short-term capital loss, no matter how long the loan was outstanding.⁸ It first offsets capital gains for the year, then up to $3,000 of ordinary income, with any remaining loss carried forward. The deduction can be taken only in the year the debt becomes totally worthless, and the lender must attach a statement to the return explaining the debt, the borrower’s identity and relationship, the collection efforts, and why the debt is worthless.

Forgiving a Family Loan

Sometimes a lender decides to forgive an outstanding balance rather than keep collecting. The treatment here is more favorable to the borrower than most people expect, but it creates work for the lender.

When a family member cancels a debt as a gift, the borrower generally does not report the forgiven amount as cancellation-of-debt income. Gifts are excluded from gross income, so the borrower’s tax picture usually doesn’t change.⁹ That’s different from commercial debt cancellation, where the borrower typically owes income tax on the forgiven balance.

The lender, on the other hand, has made a gift equal to the forgiven principal plus any accrued interest being waived. If the forgiven amount exceeds the $19,000 annual gift exclusion for 2026, the lender must file Form 709 and the excess reduces the lifetime exemption.³ Some families plan around this by forgiving a portion each year within the annual exclusion, effectively converting the loan into a series of tax-free gifts. The strategy works, but the remaining balance still has to be serviced under the original terms. If the IRS sees annual forgiveness paired with no real payments, it may conclude the loan was always a gift.

1
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
2
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
3
Internal Revenue Service. What’s New – Estate and Gift Tax
4
Internal Revenue Service. Gifts and Inheritances 1
5
Internal Revenue Service. 2025 Instructions for Schedule B (Form 1040)
6
Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction (2025)
7
Internal Revenue Service. Topic No. 453, Bad Debt Deduction
8
Office of the Law Revision Counsel. 26 USC 166 – Bad Debts
9
Internal Revenue Service. What If My Debt Is Forgiven