The IRS Has an Opinion About Your Family Loan (And It's Probably Not What You Think)

When most people first hear that the IRS has rules about lending money to family, the reaction is some combination of "wait, really?" and "oh no."

The good news: for the vast majority of family loans, the rule is so quietly forgiving that you can almost ignore it. The bad news: the people it actually catches are usually the ones who never heard it existed.

So here's the rule, in plain English, with the parts that matter to a real family — not to a hedge fund, not to a real estate trust, not to your cousin who is somehow always involved in something complicated.

The rule, in one sentence

If you lend money to a family member at less than the Applicable Federal Rate (AFR), the IRS pretends you charged the AFR anyway, and treats the difference as a gift from you to them.

That's it. That's the whole architecture.

The reason this exists is that without it, rich people would "lend" their kids a million dollars at 0%, the kid would invest it, the kid would owe no interest, and the parents would have effectively given away a bunch of money tax-free. So the IRS said: fine, lend at whatever rate you want, but if you go too low, we're going to do the math as if you charged a normal rate, and the gap is a gift.

This sounds scary. For most family loans, it isn't. Here's why.

Reason #1: the loan probably isn't big enough to matter

The IRS has a $10,000 carve-out. If the loan is $10,000 or less, the AFR rules basically don't apply, with one tiny asterisk: the borrower can't be using the money to buy income-producing property (stocks, a rental, a small business they intend to flip). For a transmission, a security deposit, a flight home, the asterisk doesn't apply. The carve-out applies. You can charge 0% and the IRS does not care.

So if you're lending your nephew $4,000 for a deposit on an apartment, you can stop reading right here. There is no rule for you to worry about. Charge what you want, charge nothing, follow the other advice we've written about how to keep the loan from blowing up the relationship — but the IRS isn't part of your problem.

Reason #2: the rate is small, and the gift exclusion is big

For loans over $10,000, here's where most people brace for impact and then nothing happens.

Imagine you lend your daughter $50,000 for a down payment. The AFR for a mid-term loan is, let's say, around 4.5% (it changes monthly — you'd look it up the month you make the loan). You decide to charge her 0% because you're a generous person and also because charging your kid interest feels weird.

By the IRS's math, you "should have" earned about 4.5% × $50,000 = $2,250 of interest in the first year. So they treat that $2,250 as a gift from you to your daughter.

Now: how big is the annual gift-tax exclusion? For one person, to one recipient, in one year, it's currently in the high teens of thousands of dollars (look up the current year — it goes up most years for inflation). Whatever the exact number, it's way more than $2,250.

So the imputed interest gets absorbed by the annual exclusion, no tax is owed, no form may even be required, and life goes on.

This is why the AFR rule, in practice, is mostly a non-event for normal family loans. The numbers it generates are smaller than the gift-exclusion bucket they fall into.

Where it actually starts to bite

The AFR rule starts to matter — meaning it actually starts costing you something — in three specific situations:

1. You're already using your annual exclusion for other gifts. If you've already given your daughter $19,000 cash for her birthday, then the imputed interest from a 0% loan to her in the same year stacks on top, and the excess starts eating into your lifetime gift/estate exemption (which is in the millions — still not necessarily a tax bill, but a number you have to start tracking on a Form 709).

2. The loan is large. Over $100,000, there's an additional wrinkle: if the borrower's net investment income for the year is under $1,000, the imputed interest is capped at zero. Over $1,000, it isn't. Translation: lend a lot of money to a kid who's also actively investing, and the math gets real.

3. You charge no interest at all and never write anything down. This is the dangerous one. If the IRS ever has reason to look at the transaction (because of an audit, an inheritance dispute, a divorce, a Medicaid application), they may decide the whole thing wasn't a loan at all. It was a gift. And if a gift exceeded the annual exclusion and never got reported, that's a real problem. (We've written a longer piece specifically on what happens when a family loan isn't documented — it's the story of how a $20,000 handshake quietly becomes a tax filing.)

The fix for #3 is almost embarrassingly simple: write it down, charge at least the AFR, and document the payments. That alone defangs the entire question. (Here's a clause-by-clause guide to what a family loan agreement needs to include.)

The actually-simple framework

If you remember nothing else, remember this:

• Loans up to $10,000: charge whatever you want (or nothing), as long as the borrower isn't using the money to buy income-producing property. The IRS isn't a player in your loan.

• Loans from $10,000 to $100,000: charge at least the AFR for the loan term you're using. Look it up the month you make the loan (the IRS publishes the rates monthly here). Document the rate. The imputed interest math probably gets absorbed by your annual gift exclusion either way, but charging AFR makes the question disappear entirely.

• Loans over $100,000: charge AFR, document everything, and call a CPA. The interactions with the borrower's investment income and your lifetime gift exemption are real, and the cost of an hour of a CPA's time is trivial compared to the cost of getting it wrong.

That's the whole framework. Three buckets. One of them needs no thought, one of them needs you to write a number down, and one of them needs a phone call.

A quick aside on what the AFR actually is

The Applicable Federal Rate is the IRS's published "this is the minimum reasonable rate of interest for a loan of this length." It comes out monthly in something called a Revenue Ruling, and it's split into three buckets:

• Short-term: loans of 3 years or less
• Mid-term: loans of more than 3 years and up to 9 years
• Long-term: loans over 9 years

You pick the bucket that matches your loan's term, look up that month's rate, and that's your minimum. You don't have to use that exact rate — you can use anything at or above it. You just can't go below it (without inviting the imputed-interest math discussed above).

The rates move with broader interest rates. In a low-rate environment, AFRs are in the 1–3% range. In a higher-rate environment like the current one, they're often in the 4–5% range. The number you charged at the start of the loan locks in for the life of the loan — the IRS doesn't make you re-rate later if rates change.

Why this is actually freeing, not scary

Here's the thing nobody tells you about the AFR rule: if you follow it, the IRS basically leaves you alone.

You're not in some gray area. You're not making a judgment call. You looked up the rate, you charged at least that, you wrote down the terms, you're tracking the payments. The IRS has a clear rule, and you followed it. There is no audit risk, no tax bill, no surprise letter five years later.

The people who get into IRS trouble with family loans are almost always the people who didn't know the rule existed and made some informal handshake arrangement that, in retrospect, was indistinguishable from a gift. Not the people who looked up a number on a Friday afternoon and wrote it down.

What this looks like in practice

If you're using a tool to manage your family loan (us, or a spreadsheet, or anything else), the only thing the AFR rule asks you to do differently is pick a non-zero interest rate when you set the loan up. That's it.

In BankOfGaga, we let you set any rate you want, because most family loans are under $10,000 and the rate genuinely doesn't matter to the IRS. But if you're lending more than that, we'd gently suggest setting your rate to the current AFR (or higher) for the term you're using. The math runs the same way; the IRS question vanishes; the borrower pays a little bit of interest that, frankly, makes the loan feel more real anyway.

BankOfGaga handles the AFR-friendly setup automatically — set the rate, term, and amount, and we generate the amortization schedule, send the reminders, and keep a running record of every payment so the loan reads as a real loan if anyone ever asks. Try it free for 3 days →

We are not a CPA. Nothing on this page is tax advice. If your loan is large, complicated, or part of a bigger estate-planning picture, please go talk to one. They are inexpensive relative to what they save you, and many of them like family loans because they're a clean, fixable thing.

The point of all this

The IRS rule about family loans exists. It's real. It's also, for the loans most families actually make, almost a non-issue.

The two-minute job of looking up the AFR and writing it down on the loan agreement is what turns a potentially complicated tax situation into a non-event. The families that do it never think about it again. The families that don't sometimes get a surprise during an audit, an inheritance, or a divorce — at exactly the moment they don't need another surprise.

Look up the rate. Write it down. Move on.

That's the whole article.