Tax Planning

Family Loans: Only Path to a Decent Home Loan Interest Rate

Bradford Institute

You may want to help a family member buy a home by making a loan to that person. That might to be the only way for a prospective homebuyer to get a decent interest rate these days. 

As this was written, the national average rate for a 30-year fixed-rate mortgage was 6.81 percent. The average rate for a 15-year fixed-rate mortgage was 6.13 percent.(1)

 If you are nice enough to follow through by making a loan to a homebuying relative, please make it a tax-smart loan that avoids unexpected, and generally adverse, federal tax consequences.

We will explain how, after first covering some necessary background information. Here goes.

Your Loan’s Interest Rate and the AFR

Most loans made to family members are called below-market loans. By that, we mean loans that charge either no interest or a rate below the IRS applicable federal rate, or AFR. The AFR is the minimum interest rate you can charge without creating unwanted federal-tax side effects for yourself.(2)

While today’s AFRs are way higher than a year or so ago, they are still low by historical standards and low compared to current commercial mortgage loan rates.

Making a loan that charges the AFR instead of a lower rate or a 0 percent rate makes a lot of sense, because you can give the borrower a good deal without giving yourself a tax headache.

AFRs for Term Loans

For a term loan, meaning one with a specified repayment date, the relevant AFR is the rate in effect for loans of that duration for the month you make the loan.(3)

Say you made a term loan to your beloved niece in April of this year so she can buy a house.(4)

  • For a short-term loan—one with a term of three years or less—made during April, the AFR is 4.86 percent (assuming monthly compounding).
  • The AFR for a mid-term loan—over three years but not more than nine years—is 4.15 percent.
  • The AFR for a long-term loan—over nine years—is 4.02 percent.

The same AFR continues to apply over the life of a term loan, regardless of how interest rates may fluctuate during that time.

Observation. The lower AFRs for longer-term loans seems weird, but it reflects the expectation that inflation will go down and interest rates will follow. Fingers crossed!

As you can see, the quoted AFRs for long-term loans (over nine years) are significantly lower than the rates charged by commercial lenders for 15-year and 30-year fixed-rate mortgages.

As long as you charge at least the AFR for a term loan to a family member, you don’t have to worry about any of the federal income tax and federal gift tax complications that we will spend much of the rest of this article explaining. 

But you are still helping out your relative by charging a rate that’s quite a bit lower than what a commercial lender would charge. It’s a win-win! 

Key point. The IRS announces updated AFRs for every month. If you make a loan after April of this year, check for the current AFRs. For example, for a loan made in May of this year, enter “May 2023 AFRs” in your browser’s search box.

Example 1. In April 2023, you made a $400,000 five-year term loan to your beloved niece to help her buy a home. You charge an interest rate of exactly 4.15 percent with annual compounding (the AFR for mid-term loans made during that month).

You will have taxable interest income based on that rate for the life of the loan, and your niece will have an equal amount of interest expense, which can potentially qualify as a deductible mortgage interest expense. More on that later.

Because you charge the AFR, you can ignore most of the rest of this article. But if you charge less than the AFR, you’ll have to keep reading for the resulting tax complications.

Variation. Alternatively, you could make a 10-year or 15-year term loan and charge the lower 4.02 percent AFR. You and your niece can always informally agree that she will try hard to pay back the loan sooner.

AFRs for Demand Loans

If you make a demand loan (meaning one that you can call due at any time) instead of a term loan, the AFR for each year will be a blended rate that reflects monthly changes in the short-term AFR rates.(5)

Therefore, with a demand loan, the effective AFR for the year can change dramatically—depending on how general interest rates move. This creates uncertainty that both you and the borrower probably would prefer to avoid.

In contrast, making a term loan that charges at least the current AFR will avoid uncertainty, because the same AFR will apply for the entire life of the loan.

Be Sure to Get Your Loan in Writing

Regardless of the interest rate you intend to charge, you’ll want to be able to prove you intended the transaction to be a legitimate loan rather than a disguised gift. That way, if the loan goes bad, you can claim a non-business bad debt deduction on your tax return.

Losses from non-business bad debts are considered short-term capital losses.(6) Short-term capital losses are not as good as ordinary losses, which you can usually deduct currently.

But short-term capital losses are still valuable tax-savers because they can offset capital gains.

If your non-business bad debt loss exceeds your capital gains for the year, you can deduct up to $3,000 of the excess against income from other sources (salary, self-employment income, interest, dividends, and so on) or up to

$1,500 if you use married-filing-separately status. Any remaining short-term capital loss gets carried forward to next year and will be subject to the same rules next year.(7)

Without a written document, your intended loan will probably be recharacterized as a gift by the IRS if you get audited. Then, if the loan goes bad, you won’t be able to claim a non-business bad debt deduction.

Also, if your intended loan is over $17,000 and is recharacterized as a gift, you’ll either owe federal gift tax (unlikely) or burn up part of your huge unified federal gift and estate tax exemption of $12.92 million (more likely) for this year.(8) The latter outcome could result in higher gift or estate taxes down the road.

Do This

Avoid these negatives by documenting your loan with a written promissory note that includes the following details:

  • The interest rate, if any.
  • A schedule showing dates and amounts for interest and principal payments
  • The security or collateral for the loan, if any

Make sure the borrower signs the note.

Key point. If your relative or friend will be using the loan proceeds to buy a house and you are charging interest, be sure to have the note legally secured by the residence. Otherwise, the borrower can’t deduct the interest as tax- law-defined qualified residence interest.

At the time you make the loan, it’s also a good idea to write a memo to your tax file, documenting reasons it seemed reasonable to think you would be repaid. Again, this supports your contention that the transaction was always intended to be a loan rather than a gift.

If you keep written financial books—such as a personal balance sheet—show a loan receivable on the asset side of your ledger. Then do the necessary bookkeeping to track interest payments, principal payments, and reductions in the loan balance.

And Do This

Secure your written loan with the borrower’s home. That way, the borrower—your beloved relative—can claim deductions for that tax-law-defined qualified residence expense, assuming he or she itemizes.(9)

Complicated Tax Rules if Your Loan Doesn’t Charge at Least the AFR

As we just explained, the tax results are straightforward if your loan will charge an interest rate that equals or exceeds the AFR. But if you insist on charging less than the AFR (or nothing), you’ll have to finesse some complicated tax rules to avoid unpleasant surprises.

When you make a below-market loan to the borrower, your beloved relative, the Internal Revenue Code treats you as making an imputed gift to the borrower.

Remember, a below-market loan charges an interest rate below the AFR. So the imaginary gift equals the difference between the AFR interest you “should have” charged and the interest you actually charged, if any. The borrower is then deemed to pay these phantom dollars back to you as imputed interest.(10)

Although this imputed stuff is entirely fictional, you must report the imputed interest as taxable income on your Form 1040. The resulting federal income tax hit is not fictional.

The good news is, you can sometimes avoid this imputed nonsense for a below-market loan by taking advantage of two tax-law loopholes.

The $10,000 Loophole

For small below-market loans, the IRS lets you ignore the imputed gift and imputed interest income rules. But to qualify for this loophole, any and all loans between you and the borrower in question must aggregate to $10,000 or less. If you pass this test, you can forget about reporting any imputed gifts and imputed interest.

But the $10,000 aggregate loan limit applies to all outstanding loans between you and the borrower, whether or not those loans charge interest equal to or above the AFR.(11)

Reality check. In the context of making a loan to help your beloved relative buy a home, this loophole is probably not big enough to be helpful.

The $100,000 Loophole

With larger below-market loans, the $100,000 loophole may save your bacon. You are eligible for the $100,000 loophole as long as the aggregate balance of all outstanding loans (with below-market interest or otherwise) between you and the borrower is $100,000 or less.(12)

First, let’s cover how the $100,000 rule works for income tax purposes. Then, we’ll explain the gift tax consequences.

Income tax consequences. For federal income tax purposes, the taxable imputed interest income to you is zero, as long as the borrower’s net investment income for the year is no more than $1,000. If the borrower’s net investment income exceeds $1,000, your taxable imputed interest income is limited to his or her actual net investment income.(13)

Example 2. You make a $100,000 interest-free loan to your adult son to help him buy a home. He has $500 of net investment income for the year. Since his investment income for the year is not more than $1,000, your taxable imputed interest income for the year is zero.

But if your son’s net investment income is $1,500, your taxable imputed interest income is $1,500.

Gift tax consequences. The gift tax results under the $100,000 loophole are a bit trickier. The simple-and-easy net investment income rule we just explained is inapplicable in the context of gift taxes.

But there’s still a way to keep things straightforward. Here’s how.

Designate the below-market or interest-free loan as a demand loan. This means you can legally demand full repayment anytime you want, even though you and the borrower may informally agree on a payment schedule.

With a demand loan, the imputed gift amount is calculated year by year and is equal to the imputed interest for that year.(14)

As long as AFRs remain anywhere close to what they are now, the imputed gift for each year will be way under the annual federal gift tax exclusion ($17,000 for 2023). If so, there will be no gift tax consequences, because the imputed gift will be less than the annual exclusion.

For purposes of computing each year’s imputed gift amount, you must use the blended short-term AFR for that year, as published by the IRS.15 Based on current AFRs, the annual imputed gift on a $100,000 interest-free demand loan would be only around $5,000.

So for 2023, unless you make other gifts to the borrower and the total gifts (including the imputed gift) exceed

$17,000, your interest-free $100,000 loan will have no gift tax consequences. If your total gifts exceed $17,000, the excess will reduce your 2023 unified federal gift and estate tax exemption of $12.92 million.

In contrast, if you make a below-market or interest-free term loan, the gift tax consequences can be more problematic (especially if, when you make the loan, AFRs are higher than now, which is very possible).

Example 3. You make a $100,000 interest-free loan calling for a balloon repayment in 10 years. This is a term loan. (Ditto if the loan calls for installment principal payments over 10 years.)

With a term loan, you’re treated as making an immediate imputed gift to the borrower equal to 10 years’ worth of imputed interest at the current long-term AFR.

 For a 10-year, $100,000 interest-free loan with a balloon payment due at the end, the imputed gift amount would be well in excess of the $17,000 annual federal gift tax exclusion. So, you’ll either owe current gift tax (very unlikely) or burn up a bit of your $12.92 million unified federal gift and estate tax exemption.

As we just explained, however, you can avoid this outcome by making a $100,000 demand loan instead of a term loan. You and the borrower can still informally agree on a 10-year balloon payment deal, if you wish.

Reality check. In the context of making a loan to help your beloved relative buy a home, even the $100,000 loophole may not be big enough to be helpful. But you never know! And you now understand how the loophole works, just in case.


Family loans can provide homebuyers with better interest rates than commercial lenders offer, especially if family members charge the AFR.

AFRs for term loans vary depending on the loan duration, and using these rates can create a win for both the lender (you) and the borrower.

If you charge less than the AFR, there may be tax complications. Two tax-law exceptions, the $10,000 and $100,000 loopholes, can be used to avoid the interest income rules that trigger taxable gifts. These loopholes may not be suitable for all home loans.

It is essential to document the loan with a written promissory note and secure it with the borrower’s home for the borrower to claim deductions for qualified residence interest expenses.


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