Overview

Using loans to children is an intergenerational planning option where parents lend funds to a child rather than making an outright gift or an immediate inheritance. When structured correctly, these loans can allow assets to leave the parent’s estate gradually, produce interest income for the parent, and let children use capital for housing, education, business startups, or other needs. However, legal, tax, and family-dynamics risks make careful documentation and professional advice essential.

(Author note: In my practice I’ve seen loans work well when parents treat them like a bank—formalized, realistic repayment terms, and regular accounting. When informal expectations crept in, relationships sometimes fractured.)

Sources and where to check current rules: the IRS publishes the monthly Applicable Federal Rates (AFR) and guidance on gift and estate taxes (see https://www.irs.gov/interest-rates and https://www.irs.gov/businesses/small-businesses-self-employed/estate-and-gift-taxes). The Consumer Financial Protection Bureau also discusses family loans and documentation best practices (https://www.consumerfinance.gov/).

Why families choose loans over gifts or trusts

  • Preserve liquidity and control: Loans let parents retain a claim on repayment and, if desired, secure the loan against an asset. That can be preferable when parents want to help but not permanently transfer control.
  • Potential estate-reduction effect: If repaid during the parent’s lifetime, the principal and future appreciation can be kept out of the estate being taxed at death (subject to correct structuring and no subsequent re-gifting).
  • Income stream: Charging interest at or above the IRS AFR produces interest income for the parent rather than triggering imputed interest rules.
  • Flexibility: Loans can be tailored—short-term, long-term, interest-only, or balloon—depending on family needs.

Key tax rules to know (overview, not tax advice)

  • Applicable Federal Rate (AFR): The IRS publishes AFRs monthly; charging at least the AFR on intra-family loans generally prevents the loan from being treated as a below-market loan that could trigger imputed interest rules under the tax code (IRC §7872). Check current AFRs at the IRS interest-rate page: https://www.irs.gov/interest-rates.
  • Gift-tax consequences: If a parent forgives principal or interest, or if a loan is reclassified as a gift, that forgiveness may use up the annual gift-tax exclusion or the lifetime exemption and could require filing IRS Form 709. See IRS guidance on gift taxes and Form 709 at https://www.irs.gov/businesses/small-businesses-self-employed/estate-and-gift-taxes and https://www.irs.gov/forms-pubs/about-form-709.
  • Reporting interest: Interest received on a family loan is generally taxable income to the lender and must be reported on their tax return.
  • Imputed interest rules: If a loan is interest-free or below the AFR, the IRS may impute interest and treat part of the foregone interest as a gift—this can complicate tax and reporting outcomes.

Because tax amounts, AFRs, and exclusion levels change periodically, confirm current numbers with the IRS or a tax advisor before implementing a plan.

Practical steps to create a defensible family loan

  1. Put terms in writing. Create a promissory note specifying principal, interest rate, amortization schedule, payment dates, late fees (if any), and remedies for default. Written terms reduce ambiguity and help with tax treatment.
  2. Charge a market-based rate—at least the AFR. If the goal is tax-neutrality, set the interest rate at or above the applicable AFR for the loan term (short-, mid-, or long-term). The IRS posts AFRs monthly (https://www.irs.gov/interest-rates).
  3. Document payments. Regular repayments (principal and interest) strengthen the lender’s position that this is a bona fide loan, not a disguised gift.
  4. Consider collateral. For larger sums, securing the loan with a mortgage or lien can protect the lender and clarify that repayment is expected.
  5. Decide on default rules and enforcement. Clarify whether and how missed payments will be handled—renegotiation, forbearance, or acceleration—so the family has a procedure rather than ad hoc decisions.
  6. Review the loan with professionals. A tax advisor can explain gift-tax filing thresholds and potential imputed interest. An attorney can prepare promissory notes and advise on state law enforcement.

Pros (benefits)

  • Estate planning flexibility: Loans can shift wealth during life while keeping the parents’ estate size more predictable.
  • Preserve control and recourse: Unlike gifts, loans give parents legal grounds to expect repayment or take collateral.
  • Interest income: Parents can earn interest rather than passively transferring capital. Proper interest keeps the IRS from treating the transfer as a gift.
  • Ability to pair with gifting: Parents can combine a loan with annual-exclusion gifts or partial forgiveness over time to move wealth tax-efficiently.

Cons and risks (what can go wrong)

  • Family strain: Missed payments, expectations, or perceived unfairness among siblings often cause conflict. Clear communication and written terms are crucial.
  • Reclassification risk: If the IRS or a court determines a loan was a disguised gift (no real expectation of repayment), the transfer could be reclassified with gift-tax consequences.
  • Imputed interest and filing complexity: Below-market loans can trigger imputed interest rules, extra paperwork, and possible gift-tax filings.
  • Default and enforcement problems: Suing a child or foreclosing on a family member can be legally possible but emotionally and practically fraught.
  • Effect on means-tested benefits and financial aid: Loaned funds, depending on how they’re documented and used, can affect financial-aid calculations or eligibility for some benefits. Check financial-aid guidance from Federal Student Aid and consult a professional.

Common structures and strategies

  • Market-rate term loan: A written loan for a fixed term at AFR or higher with regular amortizing payments.
  • Interest-only or balloon: Low monthly payments with a balloon at term’s end. Useful for young borrowers expecting higher future cash flow, but riskier for parents.
  • Loan with periodic partial forgiveness: Parents lend and forgive a small portion each year equal to the annual gift-tax exclusion (if they want to reduce estate size but avoid gift-tax reporting), but be careful: timing and documentation matter.
  • Convertible loan: The loan may be repaid or converted into a gift or equity stake in a family business, often used in estate-business transfers—best handled with legal and tax counsel.

Sample clauses and what to include in a promissory note

  • Names of lender and borrower and date of the note
  • Principal amount and purpose of the loan
  • Interest rate (state whether fixed or variable; reference AFR if desired)
  • Repayment schedule (dates, amounts, and first payment date)
  • Prepayment rights and penalties
  • Security interests or collateral description (if any)
  • Default definition and remedies (acceleration, late fees)
  • Signatures and notarization (optional but helpful)

Illustrative example (numbers are hypothetical)

A parent lends $100,000 to an adult child for a home down payment. They sign a 10‑year promissory note at a 4% fixed rate (assume 4% meets/exceeds that month’s AFR). The child makes monthly payments that amortize the loan. The parent reports interest income each year. If, after five years, the parent forgives $10,000, that forgiven portion may be treated as a gift and could require a gift-tax return depending on the annual exclusion in effect that year.

What to watch for legally and administratively

  • File a gift-tax return (Form 709) when required. Even if no tax is due, a return may be required for certain transfers—check current filing rules at https://www.irs.gov/forms-pubs/about-form-709.
  • Avoid informal oral-only loans. Courts and the IRS weigh intent and practice; consistent payments and written terms support a bona fide loan.
  • Beware of state law issues. Statutes of limitations, usury rules, or licensing requirements (rarely) can differ by state—ask a state-licensed attorney when structuring formal, secured loans.

Interaction with other wealth-transfer tools

Frequently made mistakes

  • No paperwork: Treating the loan informally increases the risk it will be recharacterized as a gift.
  • Ignoring AFR and imputed interest rules: Below-market loans can create unintended taxable consequences.
  • Forgetting to report interest income: Lenders must report taxable interest received each year.

Practical checklist before you lend

  • Decide if you want to lend or gift. If gifting, understand gift-tax consequences.
  • Draft a promissory note and have both parties sign.
  • Set a rate at or above the AFR (or document why a lower rate is being used and its tax consequences).
  • Keep clear payment records and yearly accounting.
  • Discuss the plan with a tax professional and, if needed, an attorney.

Final considerations and professional perspective

Loans to children can be a useful, flexible wealth-transfer method when used intentionally. From a planner’s perspective, success hinges on treating the loan as a genuine financial arrangement: formal documentation, realistic repayment expectations, and a plan for enforcement or forgiveness. In my experience, families who communicate expectations and document terms avoid most emotional pitfalls.

This article is educational and does not replace personalized legal or tax advice. Tax rules, AFRs, and gift-tax thresholds change; consult the IRS (https://www.irs.gov/) and a qualified tax or estate professional before acting.

Further reading on related topics:

Authoritative sources referenced:

Disclaimer: Educational only. Consult a tax or legal professional for advice tailored to your situation.