Why families use intra-family notes
Intra-family notes (aka intrafamily loans) let one family member lend money to another under a formal promissory note. When structured and documented correctly, these loans:
- Move capital to a younger family member who can invest it and capture future appreciation;
- Provide the lender with interest income and a contractual right to repayment during their lifetime; and
- Avoid treating the transfer as a taxable gift so long as the interest and other terms meet IRS rules (notably the Applicable Federal Rate).
Families with significant estates often prefer notes because they preserve lender control and convert potential estate value into a receivable that may have a lower estate impact than an outright gift. This can be an alternative — or complement — to other strategies such as outright gifts, trusts, or sales to intentionally defective grantor trusts.
(See our glossary entry on Intrafamily Loan for related definitions and examples.)
Sources and further reading: IRS — Applicable Federal Rates; IRS rules on below‑market loans (IRC §7872). For a site primer on AFRs, see our internal guide: “Applicable Federal Rate (AFR).”
Core tax rules you must know
- Applicable Federal Rate (AFR): The IRS publishes monthly AFRs. To avoid imputed interest or partial gift treatment under IRC §7872, loans that are not bona fide bargains must meet or exceed the relevant AFR for the term (short, mid, long). Check the current AFR on IRS.gov before you document a new loan. (IRS, Applicable Federal Rates).
- Imputed interest and below‑market loans: If a loan is below the AFR (or interest is not adequately stipulated), the IRS may impute interest and treat part of the financial benefit as a gift to the borrower. The imputed amount can generate taxable interest income for the lender and gift tax consequences for the lender. (IRC §7872; IRS guidance).
- Reporting: Interest received by the lender is generally taxable income and should be reported on the lender’s tax return. Verify reporting thresholds and procedures with your tax advisor; IRS reporting obligations and 1099 requirements can vary by situation.
Authoritative references: IRS — Applicable Federal Rates; IRS rules on below‑market loans and imputed interest (see IRS publications and the Internal Revenue Code, §7872).
How to set up an intra‑family note — practical steps
- Decide loan purpose and amount. Be explicit about whether the funds are for a home purchase, business investment, or education. The use can affect security, repayment capacity, and estate planning.
- Choose loan type: demand loan vs fixed‑term loan. Demand loans permit the lender to call the loan at any time; fixed‑term loans have set maturity dates. Demand loans often use the short‑term AFR; fixed‑term loans use mid or long AFRs depending on maturity.
- Set the interest rate to at least the current AFR for the applicable term. Document the AFR and the month you used it.
- Draft a written promissory note. Include: parties’ names, principal, interest rate and how it will be computed, payment schedule (principal and interest), maturity date or demand clause, default provisions, prepayment terms, and security (if any).
- Consider collateral and guarantees. Securing the loan with property or a home mortgage formalizes creditor status and is critical if the lender wants estate and creditor protection.
- Create a payment mechanism. Record interest payments and loan amortization in writing. If payments are missed, enforce the terms—or document any subsequent forgiveness as a gift with tax consequences.
- Recordkeeping and tax filings. The lender should report interest income and keep copies of the promissory note, payment history, and any correspondence. Keep a contemporaneous explanation of why terms were set using the AFR.
In my practice, thorough documentation is the single most important defense against IRS recharacterization claims. I recommend using counsel to draft or review the note and filing supporting statements with tax returns when appropriate.
Illustrative example (numeric example for clarity)
Assume a hypothetical AFR of 4% (for illustration only — check current IRS AFR before you act). A parent lends $200,000 to an adult child at 4% interest, 10‑year term, amortizing. The child uses the proceeds to buy a rental property expected to appreciate. Interest payments flow to the parent (taxable to the parent) while principal is repaid over time. The future appreciation occurs inside the child’s estate rather than the parent’s, effectively shifting potential estate growth.
If the lender had gifted $200,000 outright instead, that could reduce the lender’s lifetime gift-and-estate tax exemption (and possibly trigger gift tax reporting). The intra‑family note pushes growth into the borrower’s hands while creating a receivable for the lender.
Note: Do not rely on the illustrative AFR above. Always check the monthly AFR published by the IRS. (IRS, Applicable Federal Rates.)
Common structures and variations
- Below‑market loans: When lenders intentionally set rates below the AFR to help relatives, watch for imputed interest under IRC §7872. The tax rules can generate interest income for the lender and gift treatment for the borrower(s). (See our related glossary entries “Below‑Market Interest Rate” and “Imputed Interest.”)
- Sales to family members with notes: A sale of an asset to a family member financed with a note can shift future appreciation out of the seller’s estate if priced and documented correctly.
- Installment sales and sales to grantor trusts: These are advanced strategies that pair notes with trust planning — best handled with coordinated tax and estate counsel.
Internal resources: For definitions and tax mechanics see our entries on “Below Market Interest Rate” and “Imputed Interest” and the site primer on “Applicable Federal Rate (AFR).”
Mistakes that trigger IRS scrutiny or unintended tax costs
- Failing to document the loan: No written note equals higher risk the IRS will treat the transfer as a gift.
- Using an interest rate below the AFR without accounting for imputed interest: This may create taxable interest for the lender and a gift for the borrower.
- Forgiving payments casually: Forgiveness can convert loan principal to a taxable gift and may require gift tax reporting.
- Not reporting interest income: Lenders must include interest received in taxable income.
- Ignoring state law consequences: Contract enforceability and usury rules vary by state — what’s valid in one state may be problematic in another.
Estate planning and creditor considerations
A loan gives the lender a legal claim (a receivable) rather than giving away an asset outright. Receivables may be treated differently for estate and creditor claims than outright gifts. Properly secured notes (for example, a mortgage on purchased real property) create creditor priority and can strengthen the lender’s position if the borrower later faces creditors. Discuss state law and probate interaction with your estate attorney.
When to consider forgiveness, and how to do it safely
Sometimes lenders elect to forgive part or all of a note. Forgiveness is effectively a gift and may require gift tax reporting and use of any applicable exemptions. Partial forgiveness can also be structured over time to make use of the annual gift tax exclusion (check current exclusion amounts before doing so). Always document the forgiveness in writing and coordinate with your tax advisor.
Practical checklist before you sign an intra‑family note
- Confirm the loan purpose aligns with family goals.
- Check the current AFR and select the correct term rate.
- Draft a professional promissory note with enforcement and default provisions.
- Decide whether to secure the loan and record liens if appropriate.
- Plan for tax reporting of interest and any future forgiveness.
- Coordinate with estate planning documents so the loan fits your legacy plan.
Professional and compliance notes
- IRS guidance: Consult the IRS AFR listings and §7872 guidance before you finalize terms.
- Professional collaboration: Use a CPA (tax), an estate attorney (trusts/estate), and, when needed, a business attorney (if the loan funds a company). In my experience, multidisciplinary planning avoids surprises and preserves family relationships.
Frequently asked questions (brief)
Q: Do I have to charge AFR?
A: You should set the interest at or above the AFR for the appropriate term to avoid imputed interest.
Q: Is a written note required?
A: While some informal loans exist, a written, signed promissory note is the safest way to show a bona fide loan.
Q: Will the borrower need to report interest?
A: The borrower typically claims interest payments as deductible only if the interest is otherwise deductible by tax law (for example, mortgage interest that meets the rules). The lender reports interest received as taxable income. Consult a tax advisor for specifics.
Where to read more (authoritative sources)
- IRS — Applicable Federal Rates (AFR): https://www.irs.gov/ (search “Applicable Federal Rates”)
- Internal Revenue Code §7872 — rules on below‑market loans and imputed interest.
Internal links (FinHelp):
- Applicable Federal Rate (AFR): https://finhelp.io/glossary/applicable-federal-rate-afr/
- Intrafamily Loan: https://finhelp.io/glossary/intrafamily-loan/
- Below Market Interest Rate: https://finhelp.io/glossary/below-market-interest-rate/
Professional disclaimer: This article is educational only and does not constitute tax, legal, or investment advice. The rules for AFRs, gift tax exclusions, and related thresholds change periodically; consult a qualified tax advisor and attorney before implementing an intra‑family loan. In my practice, I advise documenting every loan and confirming AFRs for the month of origination to withstand IRS review.
