What are structured family loans and how do they work?
Structured family loans are written loan agreements between relatives that set clear repayment terms and interest. They’re a practical way for families to transfer funds for a home purchase, education, medical bills, or a business start-up while preserving estate planning flexibility and avoiding unintended gift-tax consequences—provided the loan is documented and priced to meet IRS rules.
Why families use structured loans
In my 15+ years as a financial planner I’ve seen families prefer structured loans when they want to help a loved one without: reducing the lender’s lifetime gift-and-estate tax exemption, creating confusing tax consequences, or upsetting household budgets. Unlike an outright gift, a documented loan preserves the lender’s legal claim to repayment and can support family members without permanently shrinking an estate.
The tax and legal context (short)
The IRS treats transfers as loans or gifts depending on evidence of intent to repay. Two items matter most: (1) charging at least the Applicable Federal Rate (AFR) for the loan term, and (2) creating a written agreement that documents the loan amount, schedule, and interest. See the IRS page for Applicable Federal Rates for the current AFRs and guidance (IRS.gov).
For background on gift-tax rules and reporting, consult FinHelp’s primer on how the federal gift tax exclusion works and our guide to filing when gifts exceed the annual exclusion.
- Internal link: How the Federal Gift Tax Exclusion Works — https://finhelp.io/glossary/how-the-federal-gift-tax-exclusion-works/
- Internal link: How to file a gift tax return — https://finhelp.io/glossary/how-to-file-a-gift-tax-return/
How a structured family loan typically works (step-by-step)
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Decide the purpose and amount. Lender and borrower agree on why the funds are needed and how much. Common uses: down payment, tuition, medical expenses, small-business startup, or paying off higher-interest consumer debt.
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Choose term and amortization. Agree on repayment length (months or years) and whether payments will be interest-only for a time, fully amortizing, balloon, or contingent on milestones. Using an amortization schedule clarifies principal vs. interest each payment.
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Set the interest rate at or above the AFR. The IRS publishes monthly Applicable Federal Rates; family loans should use a rate at least equal to the appropriate AFR (short-, mid-, or long-term) for the loan’s term. Using the AFR helps demonstrate the transaction is a loan, not a below-market gift.
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Put it in writing. A promissory note or loan agreement should include: names of parties, principal amount, interest rate, repayment schedule, prepayment terms, late fees or remedies, collateral (if any), and signatures.
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Use formal payment mechanics. Payments by check, ACH, or automated transfers create an audit trail. Record interest payments on tax returns as required.
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Keep records. Save the signed loan document, bank statements, cancelled checks or payment confirmations, and correspondence.
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Treat it as a real loan. Enforce the agreement consistently. Forgiving payments later can create a gift at the time of forgiveness and may require a gift-tax filing.
Examples from practice
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Home down payment: Susan lent her daughter $50,000 with a 10-year amortizing note at a fixed rate set to the mid-term AFR. Monthly payments were auto-debited and both parties kept records. Because the rate equaled the AFR and the note documented payments, the IRS would more likely view the transfer as a loan.
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Education loan: Mike lent his son $30,000 for grad school on a five-year amortization schedule at a modest above-AFR rate. The son’s timely payments helped him build credit and allowed Mike to keep the money in his estate plan.
These examples show two practical benefits: the borrower receives lower-cost, flexible credit; the lender retains control and avoids using lifetime gift exemption dollars immediately.
Tax, reporting, and common rules to remember
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Interest and principal. Interest received by the lender is taxable income; interest paid by the borrower is usually not deductible unless it qualifies under another tax rule (for example, mortgage interest rules for a primary residence). Consult a tax advisor for specifics.
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Gift versus loan. If the IRS finds the transaction lacks a real expectation of repayment (no payments, no note, or a rate below the AFR without documented business reasons), it could recharacterize the transfer as a gift. That may trigger gift-tax reporting (Form 709) and possibly reduce the lender’s lifetime exemption.
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Forgiveness. Forgiving a family loan creates a gift at the time of forgiveness and may require a Form 709. If the forgiven amount exceeds the annual exclusion for that year, it may use part of the lender’s lifetime exemption.
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Collateral and security. Secured loans (with a mortgage or lien) strengthen the borrower’s obligation and the lender’s claim but introduce complexity — consider recording documents and following state laws.
Risks to consider
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Relationship risk. Nonpayment or late payment can strain family relationships. Make expectations and consequences clear before funding the loan.
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Credit and enforcement. A family loan may not be reported on credit bureaus unless both parties agree; that can protect privacy but weakens the borrower’s incentive to repay. Consider recording the loan or reporting payments if building credit is a priority.
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Estate planning implications. A loan to a child that’s outstanding at the lender’s death becomes an asset of the estate. This can be desirable or undesirable depending on the lender’s plan.
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IRS scrutiny. Poor documentation or below-market interest rates invite questions. Use the AFR and written records to reduce risk.
Practical checklist for setting up a structured family loan
- Draft a written promissory note or loan agreement. Use an attorney or reputable template.
- Use an interest rate at or above the IRS Applicable Federal Rate for the correct loan term. Check the current AFR at: https://www.irs.gov/applicable-federal-rates
- Establish a repayment schedule and payment method (ACH, check, etc.).
- Decide on collateral or security if appropriate; follow state recording requirements for mortgages or liens.
- Keep all records and treat the loan as a businesslike transaction.
- Discuss tax reporting with a CPA or tax attorney (see IRS guidance on gifts and loan treatment).
Common mistakes and misconceptions
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Mistake: Not documenting the loan. Oral promises are much harder to defend and may be recharacterized as gifts.
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Mistake: Setting interest below the AFR or charging no interest. Below-market or interest-free loans can be treated as partially gifted and trigger reporting.
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Misconception: A family loan must be complicated or expensive. It can be straightforward when you use a clear note, a reasonable AFR-based rate, and a simple payment plan.
Frequently asked questions
Q: What if the borrower can’t repay?
A: First, consider loan-modification options (deferment, extended term, partial forgiveness) documented in writing. Remember any forgiveness is a gift at the time it is made and may require Form 709. When relationships and finances are strained, consult a mediator or attorney.
Q: Do I have to charge a market rate?
A: You do not have to charge a commercial bank rate, but you should use a rate at or above the IRS’s Applicable Federal Rate for the loan term to avoid the below-market-loan rules.
Q: When must I file a gift tax return?
A: If the transaction (or any forgiveness) is treated as a gift that exceeds the annual exclusion amount for the year, the lender must file Form 709. Check current annual exclusion amounts with the IRS or consult a tax professional.
Where to learn more (authoritative resources)
- IRS — Applicable Federal Rates and guidance: https://www.irs.gov/applicable-federal-rates
- IRS — Gift Tax and Form 709 information: https://www.irs.gov/businesses/small-businesses-self-employed/gift-tax
- Consumer Financial Protection Bureau — Loan basics and borrower protections: https://www.consumerfinance.gov/
Internal reading from FinHelp
- How the Federal Gift Tax Exclusion Works — https://finhelp.io/glossary/how-the-federal-gift-tax-exclusion-works/
- How to file a gift tax return — https://finhelp.io/glossary/how-to-file-a-gift-tax-return/
- Using Trusts vs Direct Gifts: Comparing Control, Taxes, and Flexibility — https://finhelp.io/glossary/using-trusts-vs-direct-gifts-comparing-control-taxes-and-flexibility/
Final practical advice and disclaimer
In my practice, the families that succeed with structured loans treat them as real loans: written, with on-time payments and proper tax treatment. If you want to help a family member while protecting your finances and estate plan, a documented family loan can be an effective tool — but it must be implemented carefully.
This article is educational and does not replace personalized legal, tax, or financial advice. Consult a CPA, tax attorney, or certified financial planner before creating or modifying a family loan to address your specific situation.
