Gift vs. Loan: What Are the Tax Implications?

When a significant amount of money changes hands between family members or friends, the Internal Revenue Service (IRS) views these transactions as either gifts or loans. This distinction carries distinct financial consequences for both the person providing the funds and the person receiving them. Understanding the federal tax rules that govern these transfers is important for managing personal finances and avoiding unforeseen tax liabilities. The structure of the transfer determines who may owe taxes and what documentation is required to substantiate the transaction’s true nature.

Tax Implications of a Financial Gift

A gift is a transfer of property or money to another person without receiving something of at least equal value in return. The IRS clarifies that this transfer must be made from “detached and disinterested generosity,” where the primary motive is not to gain a financial benefit but to help the recipient. For the individual receiving the funds, the amount is generally not considered taxable income and does not need to be reported on their personal income tax return.

The tax obligations associated with a financial gift fall upon the donor, the person giving the money. Federal law provides an annual gift tax exclusion, which allows an individual to give up to a certain amount to any number of people each year without any tax consequences or filing requirements. For 2025, this annual exclusion is $19,000 per recipient. A married couple can combine their exclusions, allowing them to give up to $38,000 to a single individual in 2025 without triggering a reporting requirement.

If a person gives more than the annual exclusion amount to any one individual in a single year, it does not automatically mean they will owe taxes. The excess amount is applied against their lifetime gift and estate tax exemption, which for 2025 is $13.99 million per individual. The donor must file a gift tax return, IRS Form 709, to report the gift that exceeds the annual limit. Only when an individual has exhausted their entire lifetime exemption will they be required to pay an out-of-pocket gift tax.

This high lifetime exemption amount is temporary and is scheduled to revert to a significantly lower, inflation-adjusted level after 2025 unless Congress acts to extend it. The responsibility for tracking gifts against the lifetime exemption and filing the necessary forms rests solely with the giver.

Requirements of a Bona Fide Loan

For the IRS to recognize a transfer of funds as a legitimate, or “bona fide,” loan, the transaction must have specific characteristics that demonstrate a genuine debtor-creditor relationship. The most fundamental requirement is the intent at the time of the transfer for the money to be repaid. Without these elements, the IRS can recharacterize the loan as a gift, which could trigger unexpected gift tax consequences for the lender.

A primary requirement is a formal, written agreement, commonly known as a promissory note. This document serves as a legally enforceable contract outlining the terms of the loan and establishes an unconditional promise by the borrower to repay a fixed sum to the lender. The note should be signed by both parties.

Another component is a specified repayment schedule. The loan agreement must detail how and when the loan will be paid back. This could involve periodic installment payments, such as monthly, or a single lump-sum payment on a specific future date.

Finally, a bona fide loan must include a stated interest rate that is at or above the Applicable Federal Rate (AFR). The IRS publishes these minimum interest rates monthly. Charging an interest rate below the AFR can lead to “imputed interest,” where the IRS treats the forgone interest as a taxable gift from the lender to the borrower. For the lender, the interest payments received are considered taxable income.

Documentation and Reporting for Gifts and Loans

For Gifts

When a financial gift is made for a purpose like a mortgage down payment, a gift letter is often required by lenders. This letter serves as formal proof that the funds are a true gift and not an undisclosed loan. The letter must contain the full names and contact details of both the donor and the recipient, their relationship, the exact dollar amount of the gift, and the date the funds were transferred. It must include a clear statement from the donor that the money is a gift with no expectation of repayment.

If a gift to any single individual exceeds the annual exclusion amount, the donor is required to file IRS Form 709, the United States Gift Tax Return. This form is for disclosing the gift and tracking it against the donor’s lifetime gift tax exemption. To complete Form 709, the donor will need to provide their personal information, details about the recipient, a description of the gift, its value, and any exclusions claimed.

For Loans

The cornerstone of a legitimate loan is a comprehensive promissory note. This legal document should be drafted to include all essential terms of the agreement. It must clearly state the principal amount of the loan, the interest rate being charged, and the detailed repayment terms, including the frequency of payments and the due dates.

The promissory note must be signed by both the lender and the borrower to be legally binding. Keeping accurate records of payments made and received is also important to demonstrate adherence to the loan agreement. This documentation provides clear evidence of a bona fide loan should the IRS ever question the nature of the transaction.

Consequences of Loan Forgiveness

When a lender decides to forgive a previously established bona fide loan, the act of forgiveness itself has specific tax consequences. The IRS views the cancellation of debt as a transfer of value from the lender to the borrower. At the moment the debt is forgiven, the outstanding principal balance, along with any accrued but unpaid interest, is reclassified as a financial gift.

The amount of the forgiven debt is treated as a new gift made in the year the forgiveness occurs. The lender must consider this amount in relation to their annual gift tax exclusion for that year. If the forgiven loan balance exceeds the annual exclusion limit ($19,000 for 2025), the lender will be required to file a gift tax return (Form 709).

On the gift tax return, the lender will report the forgiven debt as a gift and apply the excess amount against their lifetime gift and estate tax exemption. No immediate tax is due unless the lender’s lifetime exemption has already been fully utilized. Forgiving a loan is an affirmative act that creates a reportable gift and reduces the amount they can give away tax-free in the future or pass on through their estate.