What interest rate to charge on a family loan

Nothing requires a family lender to charge interest. A parent can lend a child $40,000 at zero percent, and the loan is valid. The complication is tax. The Internal Revenue Code assumes that a lender who charges less than a market rate is making a gift of the difference, and it taxes the arrangement as if interest had been charged anyway.

That assumption is written into section 7872, which covers below-market loans. It applies to gift loans between individuals, to loans between a corporation and a shareholder, and to loans made as compensation. For a family loan, the gift-loan rules are the ones that matter.

The rule compares the rate you charged with the applicable federal rate, or AFR. If your rate is lower, the shortfall is called foregone interest, and the code treats it as two transactions that never happened in cash.

1. The lender is treated as having made a gift of the foregone interest to the borrower.
2. The borrower is treated as having paid that same amount back to the lender as interest.

The second step is the one with a bill attached. The lender has imputed interest income and reports it on their return, even though no interest was received. The first step counts against the lender’s annual gift-tax exclusion for that borrower, and if the foregone interest plus any other gifts exceeds the exclusion, a gift-tax return is due.

For a term loan, the comparison is made once, using the AFR for the month the loan was made. The rate is then fixed for the life of the loan. For a demand loan, which has no fixed term, the comparison is made each year against that year’s rates.

The IRS publishes AFRs every month in a revenue ruling, in three bands set by the term of the loan.

• Short-term. Loans of three years or less.
• Mid-term. Loans of more than three years and up to nine years.
• Long-term. Loans of more than nine years.

Each band is published for several compounding periods. For a loan with monthly payments, use the monthly rate; for annual payments, the annual rate. The figures move with Treasury yields and are usually well below what a bank charges for consumer credit, which is why a loan at the AFR is still a good deal for the borrower.

Look up the current table on the IRS website under “Applicable Federal Rates” before you sign, and use the rate for the month of signing and the band that matches your term. Do not use a figure from a guide or a forum, which may be months out of date.

Congress wrote two exceptions into section 7872 so that small family loans are not caught by the rule.

• $10,000 de minimis exception. If the total outstanding loans between the two people never exceed $10,000, the imputed-interest rules do not apply to a gift loan, provided the borrower does not use the money to buy income-producing assets such as stocks or a rental property.
• $100,000 exception. If total loans between the two people are $100,000 or less, the imputed interest is capped at the borrower’s net investment income for the year. If that income is $1,000 or less, the imputed interest is treated as zero. The gift side of the rule still applies, but for most borrowers with modest investment income the lender’s imputed income is small or nil.

Both thresholds are tested on the total of all outstanding loans between the lender and the borrower, not loan by loan. A second advance can push an existing loan over the line. The exceptions also do not apply where a principal purpose of the arrangement is tax avoidance.

For a loan above the exception thresholds, or one that may grow past them, charging the AFR removes the problem. There is no foregone interest, so there is no imputed income and no deemed gift. The lender reports the interest actually received, and the arrangement looks like what it is: a loan.

The cost to the borrower is modest. On $50,000 over five years, each percentage point of rate adds roughly $1,300 of total interest. The AFR is typically several points below a bank rate, so the borrower is still better off than with commercial credit, and the lender earns a return that a savings account might not match.

Some lenders charge the AFR and then gift the interest back at the end of each year. That is permitted, but it must be two genuine transactions: the borrower pays, the lender reports the income, and the lender makes a separate gift. Netting them off on paper is what the rule was written to catch.

Interest received is ordinary income to the lender in the year it is received, whether or not a Form 1099-INT is issued. Keep a record of each payment and how much of it was interest. A loan ledger that splits each payment into interest and principal gives you the annual figure directly; the amortization schedule guide explains how that split is calculated.

The borrower can usually not deduct the interest. The exceptions are narrow.

• Interest on a loan used to buy, build or improve the borrower’s home may qualify as home mortgage interest, but only if the loan is secured by that home and recorded in the way the state requires. An unsecured note from a parent does not qualify.
• Interest on a loan used in the borrower’s trade or business may be a business expense.
• Interest on a loan used to buy investments may be deductible as investment interest, within limits.

Each of these has conditions that depend on the borrower’s circumstances. Treat them as questions for the borrower’s tax adviser, not as part of the lending decision.

The AFR sets the floor that avoids tax consequences. State law sets the ceiling. Every state caps the interest a private lender may charge, and the caps vary widely, with different limits for written and unwritten agreements, for loans above certain amounts, and for loans secured by real estate. A rate that exceeds the cap can make the interest unenforceable and, in some states, carries penalties.

For a family loan at or near the AFR this is not a concern. If you intend to charge a rate closer to commercial levels, check your state’s limit first.

Whatever rate you settle on, write it into the promissory note as a fixed annual percentage, together with the date the loan is made. That date is what ties the loan to a particular month’s AFR, and the fixed rate is what makes the comparison a one-time test rather than an annual one.

A note that says “interest at the AFR” without a number is a mistake. It leaves the rate to be worked out later and gives both parties something to argue about. The loan calculator shows what any fixed rate means in payments and total interest, and a loan created in NoteHouse carries the rate into the note and the schedule automatically.