Refinancing vs. Amending an Intra-Family Loan: How to Safely Lower the Interest Rate When AFRs Fall

By Timothy Burke, National Family Mortgage ®
For educational purposes only; not tax or legal advice.

This article compares two compliant ways families can adjust intra-family loan interest rates when IRS Applicable Federal Rates decline — refinancing or a documented rate amendment.

When the IRS Applicable Federal Rates (AFRs) decline, families with existing intra-family loans often ask whether they can reduce the interest rate on their loan to reflect the new, lower AFR.

The short answer is yes — but only if it is done correctly.

Because intra-family loans rely on AFRs to establish that interest is adequate for tax purposes, the IRS expects these loans to function as genuine, fixed-term debt. Improper changes to the interest rate can raise questions about whether the loan is truly fixed, whether interest should be imputed, or whether a transfer of value has occurred.

This article explains the two compliant ways to lower the interest rate on an intra-family loan, the tax considerations that apply to each, and the practical guidance families and their advisors should follow to remain aligned with IRS expectations.

Why Interest-Rate Changes Matter for Intra-Family Loans

AFRs allow families to structure loans at rates often well below commercial mortgage rates. In exchange, the IRS requires that the loan:

Have a stated principal amount
Carry a stated rate of interest
Follow a defined repayment schedule
Be documented as fixed-term debt

When interest rates are repeatedly adjusted to track AFR movements, the IRS may view the loan as having a floating or variable rate, rather than a fixed one. That characterization can trigger:

Application of blended AFR rules
Recharacterization of interest economics
Imputed interest adjustments
Potential gift-tax exposure

For this reason, families must choose a method that preserves the integrity of the loan’s structure.

There are two accepted approaches:

A true refinance
A written interest-rate amendment

Each serves a different purpose and carries different tax and administrative considerations.

Option 1: True Refinance of the Intra-Family Loan

A refinance involves paying off the existing loan and originating a new loan at the AFR in effect on the refinance date.

This approach requires:

Satisfaction of the existing promissory note
Execution of a new promissory note at the new AFR
A new amortization schedule
A new mortgage, deed of trust, or security deed
A formal closing, typically through a local settlement agent

Why a refinance is the most conservative approach

A refinance is widely regarded by tax professionals as the cleanest and most defensible method for lowering an interest rate because:

The loan’s economics reset entirely at current market terms
The AFR is applied without ambiguity
The loan clearly remains fixed-term debt
There is no risk of cumulative modifications
Audit narratives are straightforward and well supported

From an IRS perspective, a refinance eliminates arguments that the loan was informally renegotiated or incrementally altered.

Practical considerations

A refinance may require:

Temporary liquidity to pay off the existing loan at closing
Coordination with a settlement agent
Standard closing costs and documentation

While more administratively involved, a refinance provides the strongest tax position and is often preferred when long-term certainty is the priority.

Option 2: Interest-Rate Amendment to an Existing Loan

An alternative approach is to amend the interest rate on the existing promissory note through a written modification.

A rate-only amendment typically involves:

A signed written amendment by both lender and borrower
A new interest rate that is at or above the AFR in effect on the amendment date
No change to principal balance, maturity date, or payment structure
An updated amortization schedule reflecting the new rate
Continued reliance on the existing mortgage or security instrument

In most cases, a rate-only amendment does not require re-recording the mortgage, because the lien continues to secure the amended note.

When an amendment is generally considered appropriate

Many tax practitioners view a limited number of well-documented rate amendments as reasonable when:

The AFR has declined meaningfully
The amendment is the first or second rate change
The loan otherwise remains unchanged
The revised rate meets or exceeds the current AFR
The modification is properly documented and retained

This approach is commonly used when families want to reduce interest expense without undertaking a full refinance.

Risks of repeated amendments

A pattern of repeatedly lowering the rate to follow AFR movements can undermine the fixed-term nature of the loan. In such cases, an IRS examiner may argue that:

The loan functions as a floating-rate instrument
A blended AFR should apply
The cumulative changes constitute a significant modification
A reduction in interest represents a transfer of value

For this reason, amendments should be used sparingly and deliberately, not as a routine response to every AFR change.

Key Tax Considerations

Fixed-Term vs. Floating-Rate Debt

The IRS distinguishes between fixed-term debt and instruments whose economics vary with market conditions. Frequent interest-rate changes tied to AFR movements may invite scrutiny regarding the loan’s classification.

Blended AFR Risk

Under Treasury Regulation §1.1274-3, repeated or substantial changes to loan terms may require application of a blended AFR, which can result in a higher effective rate than anticipated.

Gift-Tax Exposure

If a lender voluntarily accepts less interest than required without adequate consideration, an examiner may argue that the present value of the forgiven interest constitutes a gift. Proper documentation and AFR compliance materially reduce this risk.

Significant Modification Analysis

Treasury Regulation §1.1001-3 provides rules for determining whether a modification results in a deemed exchange of debt. A single, rate-only amendment is often not significant on its own, but multiple or combined changes can meet the threshold.

Choosing Between a Refinance and an Amendment

A refinance may be preferable when:

Maximum IRS defensibility is desired
The family wants a clean reset of loan terms
Multiple future rate changes are possible
Long-term certainty outweighs administrative cost

An amendment may be appropriate when:

This is the first or second adjustment
The AFR decline is substantial
Only the interest rate is changing
The family seeks a simpler, lower-cost solution

Practices to avoid

Repeated rate changes over short periods
Informal or undocumented agreements
Retroactive application of new rates
Combining rate changes with other material term changes

Documentation and Servicing

Regardless of method, families should ensure that:

All changes are documented in writing
All parties sign the relevant documents
Amortization schedules are updated
Payment records remain consistent with the revised terms

If a third-party loan servicer is used, the servicer should receive the executed documents so records and statements accurately reflect the loan as amended or refinanced.

Frequently Asked Questions

Can we simply change the interest rate on our existing intra-family loan?
Yes, but only through a properly documented process. Families may either refinance the loan entirely or execute a written interest-rate amendment. Informal or verbal changes are not sufficient.

Does lowering the interest rate create a gift?
It can, if the lender voluntarily accepts less interest without proper documentation or without meeting the AFR in effect at the time of change. Using the current AFR and documenting the change helps mitigate this risk.

How many times can an interest rate be amended?
There is no explicit numerical limit in the tax code. However, repeated amendments may lead the IRS to question whether the loan is truly fixed-term. Many practitioners view one or two well-documented amendments as reasonable.

Is a refinance required to lower the rate?
No. A refinance is not required, but it is the most conservative and defensible approach. A rate-only amendment may be appropriate in limited circumstances.

Does a rate amendment require re-recording the mortgage?
In most cases, no. A rate-only amendment generally does not require re-recording because the existing mortgage or deed of trust continues to secure the amended promissory note.

Can the new interest rate be lower than the AFR?
No. The revised rate must meet or exceed the AFR in effect on the date of the refinance or amendment to avoid imputed interest and related tax issues.

Can the new rate apply retroactively?
No. Interest-rate changes should apply prospectively only, beginning on or after the effective date of the refinance or amendment.

Is a blended AFR ever required?
In limited circumstances, a blended AFR may apply if repeated or significant changes cause a loan to be treated as modified debt under applicable Treasury regulations.

Conclusion

Lowering the interest rate on an intra-family loan when AFRs fall is permissible under the Internal Revenue Code, but it must be done with care.

Families have two compliant options:

A true refinance, which offers the strongest tax defensibility
A limited, well-documented interest-rate amendment, when used appropriately

The correct choice depends on the family’s objectives, tolerance for administrative complexity, and the importance of long-term certainty.

Because tax consequences depend on individual circumstances, families should consult their attorney, financial advisor, or tax professional before modifying or refinancing an intra-family loan.

Technical Appendix

Relevant Authorities and Concepts

Internal Revenue Code §§ 1274 and 7872
Treasury Regulation §1.1274-3 (blended AFR concepts)
Treasury Regulation §1.1001-3 (significant modification rules)
Fixed-term debt characterization principles
Gift-tax valuation concepts related to interest concessions

Documentation Best Practices

Written promissory note amendments for any rate change
Clear identification of the AFR in effect on the modification date
Updated amortization schedules reflecting revised terms
Consistent servicing and payment records
Retention of all historical loan documents

About the Author

Timothy Burke is the founder of National Family Mortgage ®, an online company focused on helping families document and support compliant intra-family mortgage loans and seller-financed home transactions. His work focuses on proper documentation, alignment with applicable federal tax rules, and practical implementation considerations for families and their professional advisors navigating private family financing.

Families and their advisors should consult applicable statutes, regulations, case law, and professional guidance when applying these principles to specific transactions.