What Is the Lowest Interest Rate You Can Charge a Family Member?

Lending money to family members can be a generous way to provide financial assistance, offering more flexible terms than traditional lenders. While such loans often stem from a desire to help, they involve important tax considerations that both the lender and borrower should understand. The Internal Revenue Service (IRS) scrutinizes transactions between family members to ensure they are legitimate loans and not disguised gifts, which can have unintended tax implications.

The Importance of Interest in Family Loans

Charging interest on a family loan is crucial because loans between related parties are subject to IRS rules preventing tax avoidance. If a loan is made with no interest or an interest rate below what the IRS considers adequate, the IRS may treat the forgone interest as “imputed interest.” This means the IRS considers that interest was paid to the lender and then gifted back to the borrower. The lender could then be taxed on this “phantom” income, even if no cash interest was actually received.

If the interest rate is too low, the difference between the appropriate rate and the actual rate charged is treated as a gift from the lender to the borrower. If this deemed gift, combined with any other gifts made to the individual during the year, exceeds the annual gift tax exclusion ($19,000 per recipient for 2025), the lender may be required to file a gift tax return. While the lifetime gift tax exemption is substantial ($13.99 million per individual for 2025), these transactions still require proper reporting and can reduce the available lifetime exemption.

Determining the Applicable Federal Rate (AFR)

The Applicable Federal Rate (AFR) is the lowest interest rate you can charge on a family loan. The IRS publishes these rates monthly as the minimum interest rate for private loans. AFRs are based on the average market yields of U.S. Treasury obligations from the preceding month, reflecting current economic conditions. They are generally lower than commercial lending rates, making family loans with AFRs attractive.

There are three categories of AFRs, determined by the loan’s term: short-term (three years or less), mid-term (between three and nine years), and long-term (exceeding nine years). The specific AFR for a term loan is the rate in effect for the month the loan is made, and this rate remains fixed for the loan’s duration.

Structuring a Compliant Family Loan

Proper documentation is essential to ensure a family loan is recognized as legitimate by the IRS. A written loan agreement, or promissory note, is required. This document serves as legal evidence of the debt and should clearly outline the terms and conditions agreed upon by both parties. Without a formal agreement, the IRS may argue the transaction was a gift, leading to potential tax issues.

The promissory note should include several key elements. It must specify the principal amount being loaned, the interest rate (at least the applicable AFR), and a defined repayment schedule. This schedule can involve installment payments or a lump-sum repayment. The agreement should also detail terms for default, late payments, and any collateral involved. Consistent, documented payments are crucial to demonstrate a true lender-borrower relationship.

Ongoing Tax Considerations

Once a family loan is established, ongoing tax responsibilities arise for both the lender and the borrower. The lender must report any interest received from the loan as taxable income on their federal income tax return. This income is treated like any other interest income and is subject to applicable income taxes. Even if the interest is imputed, meaning no cash exchanged hands, the lender is still liable for income tax on that calculated amount.

For the borrower, interest paid on a personal loan is generally not tax-deductible. Limited exceptions exist if the loan proceeds are used for business expenses, qualified education expenses, or certain taxable investments, though these typically do not apply to general family loans. If a loan is forgiven or canceled, this can trigger additional tax consequences. Loan forgiveness is usually considered a gift from the lender to the borrower, subject to gift tax rules for the lender and taxable income for the borrower. Maintaining clear records of all payments and any changes to the loan terms is important for tax reporting.