How to Structure Family and Personal Loans the Right Way

Comments Off

Lending money to family or friends can be a great way to help them out in a time of need or give them favorable terms while keeping banks and the underwriting requirements out of the equation. Personal loans can be used to buy a home, a car, or help fund education.

While lending money to family or friends can seem like a simple, keeping-it-in-the-family arrangement, the IRS sees things differently.

Personal loans to family and friends can impact the taxes of the lender and the borrower if not done right. When personal loans aren’t properly documented or charged an appropriate interest rate, they can trigger unintended tax consequences such as imputed income, gift taxes, or lost deductions.

This guide explains how to document loans correctly, comply with the Applicable Federal Rate (AFR) rules, and understand the resulting tax treatment for both lender and borrower.

Why Proper Documentation Matters

When you lend money to a family member or friend, it’s critical to demonstrate that the transaction is a bona fide loan rather than a disguised gift. Proper documentation not only provides legal clarity but also protects both parties in the event of tax scrutiny or future disputes.

The IRS looks for clear evidence that repayment was expected from the beginning. To support this, follow these best practices:

Create a Written Promissory Note: Put the terms in writing, including the loan amount, interest rate, payment schedule, maturity date, and any collateral pledged. Both parties should sign and date the document.
Charge an Appropriate Interest Rate: Reference the current Applicable Federal Rate (AFR) to ensure the interest rate meets minimum IRS requirements. Charging less than the AFR can result in imputed income and gift reporting obligations.
Set a Definite Repayment Schedule (aka Amortization Schedule): Outline regular, periodic payments — whether monthly, quarterly, or annually. Avoid open-ended or indefinite repayment terms, which suggest a gift rather than a loan.
Keep Financial Records: Maintain a record of payments received, interest calculations, and remaining balances. If you track your personal finances, record the loan as an asset (“loan receivable”) on your balance sheet.
Use Traceable Accounts: Transfer funds through a traceable method such as a bank transfer or check. Avoid cash exchanges, as these make it harder to verify the transaction later.
Secure the Loan When Appropriate: If the borrower is using the funds to purchase property, consider recording a lien or mortgage against the asset. A secured loan provides both parties with legal protection and demonstrates the lender’s expectation of repayment.
Document Your Intent and Reasoning: Retain a brief memo or email explaining why the loan was made and why repayment was expected to be reasonable at the time. This kind of contemporaneous note can be valuable evidence if questions arise later.
Follow Through on Payments: Enforce the terms of the agreement — collect payments on schedule and issue reminders or statements if needed. Consistent administration reinforces that the loan is legitimate and not a casual or implied gift.

Setting the Interest Rate

A key feature and benefit of a personal loan is that you can charge a lower interest rate than what they might be able to obtain through a bank or other loan option. However, the rate you choose will have implications. To understand this, you have to understand the Applicable Federal Rate or AFR.

The AFR represents the minimum interest rate the IRS considers adequate for a loan between related parties without triggering the imputed interest and gift tax rules. To be clear, you can set an interest rate below AFR but you should be aware of the implications of doing so.

Rates are published monthly by the IRS and categorized by term length:

Short-Term AFR: Loans with repayment periods of up to 3 years
Mid-Term AFR: Loans between 3 and 9 years
Long-Term AFR: Loans longer than 9 years

The latest rates are found here: Applicable Federal Rates | Internal Revenue Service

Once a term loan is established, the AFR in effect for that month remains valid for the life of the loan, regardless of later rate changes.

Interest Rates At or Above the AFR

When you set the rate at or above the AFR, things are much simpler.

Lender’s Perspective:
- The lender must report the actual interest received as ordinary income on their tax return.
- Because the interest rate satisfies IRS minimums, there is no imputed interest or deemed gift component.
- The loan remains an asset of the lender’s estate and should be documented accordingly. Unpaid family loans are considered assets of your estate. The executor must collect or account for them before settling other debts or distributing inheritances. A will or trust should specify whether loans are to be repaid, forgiven, or offset against an heir’s inheritance.

Borrower’s Perspective:
- The borrower pays the agreed interest as part of each payment.
- The ability to deduct that interest depends on how the borrowed funds are used:
  - Personal Use (e.g., debt consolidation, car purchase): Interest is not deductible.
  - Investment or Business Use: Interest may be deductible subject to applicable limits under Sections 163(d) and 163(j).
  - Home Purchase: If the loan is properly secured by the residence and recorded as a mortgage, the interest may qualify as deductible home mortgage interest.

Interest Rates Below the AFR

When you set the rate below the AFR, things get complicated

Lender’s Perspective:
- The lender must report the actual interest received as ordinary income on their tax return. Additionally, the lender is deemed to have received the foregone interest as taxable income.
- Because the interest rate does not satisfies IRS minimums, the lender is deemed to have gifted to the borrower the present value interest in the difference between the actual loan and what should have been charged.
  At the time the loan is made, the present value (PV) of all payments is compared under two scenarios:
  - One using the AFR as the interest rate, and
  - One using the actual interest rate charged.
  The difference between these two PVs represents the initial gift amount.
  This may result in the requirement to file IRS Form 709 if they are over the annual exclusion limit.
- The loan remains an asset of the lender’s estate and should be documented accordingly.

Borrower’s Perspective:
- Same as Above

Small Loan Exemptions

There are two exemptions from some of these consequences.

The $10,000 Exception
- If total outstanding loans between lender and borrower are $10,000 or less, no imputed interest or gift applies — unless the loan funds are used to buy income-producing assets.
The $100,000 Exception
- If total loans are $100,000 or less and the borrower’s net investment income is under $1,000, no imputed interest applies.
- If investment income exceeds $1,000, the lender must report the lesser of the borrower’s investment income or the imputed interest.

With careful planning, family loans can help loved ones without creating unexpected tax headaches. A properly structured loan protects both the relationship and your financial integrity.