Intrafamily Loan

An intrafamily loan is a loan made between family members, most often from a parent to an adult child, that is deliberately structured to comply with the Internal Revenue Code's below-market loan rules. Its appeal is a low interest rate: because the IRS only requires a family lender to charge the Applicable Federal Rate, a relative can borrow far more cheaply than from a bank while the lender still earns modest interest. The structure matters because a loan that charges too little interest is not treated as a generous loan but as a partial gift, with gift-tax consequences.

The governing rule is IRC Section 7872, the below-market loan provision. If a lender charges a family borrower less than the Applicable Federal Rate, the difference between the AFR and the rate actually charged is "forgone interest." For a gift loan, that forgone interest is treated as though the lender gave it to the borrower as a gift, and the borrower paid it back as interest, each year the loan is outstanding. So charging no interest does not avoid tax; it converts the interest into an annual gift.

Two thresholds soften this. First, a de minimis exception: gift loans between individuals that aggregate to $10,000 or less are generally exempt from the imputed-interest rules altogether, unless the loan proceeds are used to buy income-producing assets. Both figures, the $10,000 and the $100,000 below, are fixed statutory amounts, not indexed for inflation. Second, for gift loans of $100,000 or less, the amount of interest imputed to the lender is capped at the borrower's net investment income for the year, and if that net investment income is $1,000 or less, it is treated as zero. In practice this means a parent can make a substantial family loan and, if the child has little or no investment income, report little or no phantom interest.

The Applicable Federal Rate is the linchpin, and it changes every month. The IRS publishes short-term (a term not over three years), mid-term (over three years but not over nine) and long-term (over nine years) AFRs monthly, in the boundary words IRC 1274(d)(1)(A) itself uses, and the rate in effect when the loan is made generally governs a fixed-rate note for its life. Never rely on a fixed AFR figure quoted in an old article; check the current AFR for the loan's term. The other tax exposure is forgiveness: if the lender later cancels part of the balance, the cancelled principal is a gift in that year, which can be sheltered by the annual gift-tax exclusion or, above it, the lifetime exemption. To make the loan hold up, families document it with a signed promissory note stating the amount, rate, term and repayment schedule, and the borrower actually makes payments.

Suppose a parent lends an adult child $200,000 to help buy a house, using a written promissory note. Because the loan exceeds $100,000, the parent must charge at least the long-term Applicable Federal Rate for the note's term to avoid imputed interest. If the current long-term AFR were 4% (illustrative only, the real rate is published monthly and changes), the note would charge 4% and the parent would report that interest as income, while the child pays a rate far below a commercial mortgage.

Now take a smaller loan of $80,000 at zero interest. Because it is $100,000 or less, the interest imputed to the parent is capped at the child's net investment income for the year. If the child has no investment income, the imputed interest is zero and there is no gift or income to report, even though the loan charges nothing. If instead the loan were only $9,000 at zero interest and not used to buy income-producing assets, the de minimis exception would exempt it entirely. These figures are hypothetical; the AFR and each family's facts drive the real result.

Pros

• The borrower pays only the Applicable Federal Rate, typically far below bank or credit-card rates.
• Interest paid stays within the family rather than going to a lender.
• For loans of $100,000 or less to a borrower with little investment income, the imputed-interest reporting is often zero.
• A documented note keeps the transfer a loan, not a gift, preserving the lender's gift-tax exclusion and lifetime exemption.

Cons

• Charging less than the AFR converts the discount into a taxable gift under IRC Section 7872, defeating the purpose if done carelessly.
• The lender must report AFR interest as taxable income, even on a loan to a child.
• The AFR changes monthly, so the rate must be checked at the time the loan is made and documented.
• Forgiving principal later is a gift in that year, and an undocumented "loan" the IRS recharacterizes as a gift can create unexpected gift-tax filing.