What Is an Intrafamily Loan and How Does It Work?

An intrafamily loan is a formal financial transaction between family members, structured as a legitimate debt rather than an informal gift. This arrangement allows one family member to lend money to another for significant purchases, like a house or a business, under defined terms. When properly structured, these loans can be a tool for transferring wealth between generations without incurring gift or estate taxes.

The loan must be treated with the same seriousness as one from a traditional financial institution. This requires a formal agreement, a set repayment schedule, and the charging of interest. Failing to formalize the loan can lead the Internal Revenue Service (IRS) to reclassify the transaction as a gift, which can trigger tax liabilities for the lender.

Establishing a Bona Fide Debt

For the IRS to respect an intrafamily loan, it must qualify as a “bona fide debt.” This legal standard means a genuine debtor-creditor relationship was intended when the funds were transferred. The transaction cannot be a gift disguised as a loan, and the IRS examines the facts and circumstances of the arrangement to determine its true nature.

A primary factor is the borrower’s realistic ability to repay the loan. The lender must have a reasonable expectation that the borrower has the financial capacity, through income or assets, to make the required payments. A loan to a family member with no clear path to repayment is more likely to be classified as a gift by the IRS.

Another element is the presence of formal loan terms detailed in a promissory note. This includes a specified repayment schedule and an interest rate. The actions of both parties must align with this agreement, with the lender making reasonable efforts to collect the debt and the borrower making consistent payments.

A legitimate loan agreement also outlines the consequences for non-payment. This could include the seizure of collateral if the loan is secured. The presence of these enforcement mechanisms reinforces the seriousness of the financial obligation and distinguishes it from a gift.

Determining the Minimum Interest Rate

A legitimate intrafamily loan must charge an adequate amount of interest. To prevent these transactions from becoming disguised tax-free gifts, the IRS mandates a minimum interest rate known as the Applicable Federal Rate (AFR). These rates are derived from U.S. Treasury yields and are published monthly by the IRS.

The correct AFR to use depends on the loan’s duration. The IRS provides three rates: a short-term rate for loans of three years or less, a mid-term rate for loans between three and nine years, and a long-term rate for loans over nine years. The lender must use the rate that corresponds to the loan’s term in the month the loan is made.

Failing to charge at least the AFR has tax implications for the lender due to “imputed interest.” The IRS calculates the difference between the interest that should have been collected using the AFR and the amount actually paid. This shortfall, or foregone interest, is treated as a gift from the lender to the borrower. If this amount, plus any other gifts to that borrower in the same year, exceeds the annual gift tax exclusion ($19,000 for 2025), the lender may need to file a gift tax return.

This imputed interest is also treated as taxable income for the lender. The lender must report the foregone interest and pay income tax on it, even though no money was collected. This rule prevents family loans from being used as a loophole to transfer wealth and avoid income tax.

Creating the Promissory Note

The promissory note is the legally binding document that formalizes the intrafamily loan and serves as primary evidence of the bona fide debt. This written agreement must contain specific terms that outline the obligations of both the lender and the borrower. It transforms a casual family arrangement into a formal financial contract, which is necessary for tax compliance and legal enforceability.

A promissory note must include:

• The full legal names and addresses of the lending and borrowing parties.
• The principal amount of the loan and the date the funds are disbursed.
• The interest rate being charged, which should be equal to or greater than the applicable AFR.
• A clear repayment schedule, specifying when payments are due and the amount of each payment.
• A description of any collateral securing the loan, such as a car or a house, if applicable.
• Clauses that address the consequences of late payments or default, such as late fees or an acceleration clause.

Both the lender and the borrower must sign and date the document. It is often advisable to have the signatures notarized to add a layer of authenticity, although it is not always a strict legal requirement.

Annual Tax and Record-Keeping Obligations

Both the lender and borrower have ongoing responsibilities that involve tax reporting and diligent record-keeping to maintain the loan’s integrity. Adhering to these annual procedures is just as important as the initial setup of the loan.

For the lender, the interest received from the loan is considered taxable income and must be reported on their federal income tax return. If the interest paid by the borrower exceeds a certain threshold in a calendar year, the lender may also be required to issue a Form 1099-INT to the borrower and file a copy with the IRS.

The borrower’s ability to deduct the interest they pay is limited, as interest on most personal loans is not deductible. An exception exists if the loan is structured as a mortgage to buy, build, or substantially improve a primary or secondary residence and is secured by that property. In such cases, the borrower may be able to deduct the interest payments.

Both parties must maintain meticulous records for the life of the loan. The lender should keep a detailed log of all payments received, and the borrower should retain proof of all payments made, such as canceled checks or bank transfer records. These records serve as evidence that both sides are upholding the terms of the loan agreement.