Imputed Interest and the Borrower’s Mortgage Interest Deduction in Intra-Family Mortgages Over $100,000

 

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

 

Intra-family mortgage loans often feel straightforward: a parent lends funds, a child makes payments, and everyone expects the arrangement to work like a traditional mortgage. Federal tax law treats these loans differently. The Internal Revenue Code contains “below-market loan” rules designed to prevent interest-free or low-interest family loans from functioning as disguised gifts.

Families in this situation are usually asking two practical questions:

1. If the IRS requires interest income to be recognized on a family mortgage, does the borrower get a corresponding interest deduction?
2. If so, what documentation is required for the borrower to claim it–especially when the loan amount is over $100,000?

The answer is that the lender’s interest income and the borrower’s deduction are governed by different rules. A family loan can be treated as having interest for income-tax purposes under the imputed-interest rules, while the borrower’s ability to deduct interest depends on whether the debt qualifies as home mortgage interest under current law and is secured by a qualified residence.

 

What “imputed interest” means in family loans

The IRS does not ignore below-market family loans

When a family loan charges no interest or less than the required minimum rate, the IRS may treat the loan as if interest were charged at a government benchmark rate and then “paid back” in a circular flow. This is the basic concept of imputed interest.

For income-tax purposes, this can create:

• interest income to the lender, and
• a corresponding interest expense conceptually attributed to the borrower,

even if the borrower did not actually write a separate check labeled “interest” in the way a bank mortgage would.

The governing framework is generally associated with IRC §7872 (below-market loans) and the federal rate structure referenced in related provisions.

Why the AFR still matters

In family mortgage loans, the most common way to avoid imputed-interest complications is to charge at least the Applicable Federal Rate (AFR) in effect for the month the loan is made, matched to the loan’s term. This is one reason properly documented intra-family mortgages typically use AFR-based interest rather than “0%” or “whatever feels fair.” When interest rates change after a family loan is in place, families sometimes explore changes to an existing intra-family mortgage, which must be handled carefully to remain consistent with federal tax rules.

 

The $100,000 concept: what it does–and what it does not do

Families often hear that “under $100,000 is different” and assume it is a broad safe harbor. It is not.

A key special rule applies to certain gift loans directly between individuals when the aggregate outstanding amount does not exceed $100,000. In that case, the amount of interest treated as transferred back to the lender for income-tax purposes is generally limited to the borrower’s net investment income, subject to conditions and exceptions.

Three important clarifications:

• This rule is not a general exemption from interest. It is a limitation that can apply in a narrow fact pattern.
• It does not automatically remove the need for a properly stated interest rate in a mortgage-style family loan.
• Loans over $100,000 typically do not benefit from this limitation, which is why families often focus on AFR compliance in larger intra-family mortgages.

 

Lender reporting and borrower deductibility are separate questions

It is tempting to treat this as symmetry: “If the lender has interest income, the borrower should get a deduction.” The tax code does not work that way.

When interest may be taxable to the lender

The lender’s tax reporting depends on:

• the stated loan terms (rate, payment schedule, principal balance),
• whether the interest is adequate under the applicable federal rules, and
• whether imputed-interest rules apply.

Even in a family setting, interest that is properly stated and paid is generally treated as interest income.

When interest may be deductible to the borrower

A borrower’s ability to deduct mortgage interest generally depends on whether the interest is qualified residence interest, which is subject to eligibility rules and limitations under current law and IRS guidance (commonly described in IRS Publication 936).

Critically, for a family loan to be treated as a mortgage for deduction purposes, the debt generally must be secured by the home (meaning the lender has a valid lien–typically a mortgage or deed of trust–consistent with state law). IRS guidance on the home mortgage interest deduction emphasizes secured debt and other requirements.

 

Why a recorded mortgage lien matters for borrowers who want the deduction

The deduction is tied to “secured” home debt

In ordinary residential lending, the borrower receives a Form 1098 from a bank and deducts interest as home mortgage interest if eligible. In family lending, there is often no institutional servicer and no routine Form 1098. The absence of a 1098 does not automatically prevent a deduction, but it usually increases the importance of clean documentation.

If the family intends the borrower to have the best opportunity to treat interest as deductible home mortgage interest (when the rules otherwise allow it), the arrangement typically needs:

• a written promissory note with stated interest and repayment terms, and
• a mortgage-style security instrument (mortgage, deed of trust, or security deed) that is properly executed and recorded as required in the property’s state.

Recording does two practical things:

1. It supports the “secured debt” characteristic expected of mortgage interest treatment.
2. It creates clarity and enforceability that helps the documentation align with the economic reality of a mortgage loan.

A common misunderstanding: “We can still call it mortgage interest without a lien”

Families sometimes use the word “mortgage” informally to describe any home-related loan. For deduction purposes, the analysis is typically stricter. If the debt is not actually secured by the residence, it is often harder to treat it as qualified residence interest under current rules and IRS guidance.

 

What this arrangement is–and is not

• This is: a documented intra-family mortgage loan secured by a recorded lien, with interest stated at an adequate rate.
• This is not: a casual “pay us back when you can” arrangement if a mortgage interest deduction is a goal.
• This is not: automatic tax symmetry–lender income does not guarantee borrower deductibility.

 

Frequently Asked Questions

What is imputed interest in a family loan?

Imputed interest is interest the IRS can treat as charged (and transferred) on a below-market loan, even if the stated rate is too low or the loan is interest-free. These rules are commonly associated with IRC §7872.

If a parent charges 0% interest on a mortgage to a child, does the IRS care?

Potentially, yes. Below-market loan rules may apply, and families often use AFR-based interest to align the loan with federal standards and avoid imputed-interest complications.

Does the $100,000 rule mean we can ignore interest if the loan is under $100,000?

Not as a general rule. The $100,000 concept is tied to a special limitation for certain gift loans between individuals and is subject to conditions. It is not a blanket exemption from interest or documentation.

If the lender reports interest income, can the borrower deduct the interest?

Not automatically. The borrower’s deduction depends on whether the interest qualifies as deductible home mortgage interest under current rules and whether the debt is secured by a qualified residence, among other requirements described in IRS guidance (including Publication 936).

Do we need a recorded mortgage or deed of trust for the borrower to claim a mortgage interest deduction?

If the goal is to treat the interest as home mortgage interest, the debt generally needs to be secured by the home. A properly executed and recorded mortgage lien is a common way to support that “secured debt” requirement.

Can the borrower deduct interest if they take the standard deduction?

Generally, no. Mortgage interest is claimed as an itemized deduction when the rules allow it; borrowers using the standard deduction typically do not separately deduct mortgage interest.

Does it matter how the borrower uses the loan proceeds?

Yes. Whether interest qualifies as deductible home mortgage interest depends in part on how the loan proceeds are used, along with other limitations under current rules.

Does a family lender have to issue a Form 1098?

Family lenders do not typically operate like institutional lenders, and Form 1098 is not always issued in private family lending. Clear records and substantiation can still be important for tax reporting.

 

Conclusion

Imputed-interest rules exist to prevent below-market family loans from functioning as disguised gifts. For larger intra-family mortgages, charging an adequate interest rate and documenting the arrangement as real debt are central to aligning the loan with federal tax expectations.

Separately, a borrower’s ability to deduct interest is governed by home mortgage interest rules that focus on whether the debt is secured by a qualified residence and otherwise qualifies under current law and IRS guidance. For families who want the borrower to have the best opportunity to claim a deduction when eligible, a recorded mortgage lien–and clean, consistent documentation–often matters as much as the interest rate itself.

 

Technical Appendix: Code Sections and Practical Tax Concepts

1) Imputed interest and below-market loans

• IRC §7872 provides the core framework for below-market loans and imputed-interest treatment.
• Special rules for certain gift loans between individuals include the $100,000 limitation concept tied to the borrower’s net investment income, subject to conditions and exceptions.

2) Home mortgage interest deductibility

• IRS Publication 936 explains rules governing the deductibility of home mortgage interest, including secured debt concepts, limitations, and reporting mechanics for individuals.
• Professional summaries of the statutory framework commonly reference IRC §163(h) and related provisions as the basis for qualified residence interest rules and limitations.

3) The “secured by the home” concept

For a loan to be treated as a mortgage for deduction purposes, the debt generally must be secured by the residence under applicable standards. In practice, families typically satisfy this by executing and recording a mortgage or deed of trust consistent with state law and maintaining records that match the written terms.

 

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.

 

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