Why You Can’t “Buy Down” an
Intra-Family Loan Rate
— Even With Points
Why You Can’t “Buy Down” an Intra-Family Loan Rate — Even With Points
By Timothy Burke, National Family Mortgage ®
For informational purposes only; not tax or legal advice.
Executive Summary
When families make loans to one another or sell real estate using seller financing, they often look to familiar tools from traditional mortgages for guidance. One question comes up again and again:
If borrowers can pay points to lower the interest rate on a bank mortgage, why couldn’t the same approach work for an intra-family loan?
At first glance, the idea seems reasonable. Paying points is common in commercial lending, and economically it appears to leave the lender whole. But under the Internal Revenue Code, family loans are governed by a very different set of rules.
Under Sections IRC §7872 and IRC §1274, the IRS does not evaluate family loans the way banks do. Instead, it applies strict standards designed to prevent disguised gifts and unreported interest income. As a result, attempting to “buy down” an intra-family loan rate below the Applicable Federal Rate (AFR) almost always creates tax problems rather than solving them.
The Applicable Federal Rate Is Not Negotiable
For the statutory purpose behind AFRs–and why they aren’t market mortgage rates–see Why, How, and When the IRS Sets Applicable Federal Rates (AFRs).
The IRS publishes Applicable Federal Rates (AFRs) each month. These rates represent the government’s benchmark for what constitutes adequate interest on loans between related parties.
For intra-family loans, the AFR functions as a floor. If a loan’s interest rate is below the AFR that applies to its term at the time the loan is made, the loan is classified as a below-market loan under Section 7872.
Once a loan falls into that category, the tax consequences follow automatically:
- The lender is treated as having received imputed interest income, even if no interest was actually paid.
- The same amount is treated as a gift from the lender to the borrower.
These consequences apply regardless of intent. The IRS does not ask whether the family was trying to be generous or creative. It simply applies the statutory framework.
Why Points Work for Banks but Not for Families
In commercial lending, discount points are a pricing mechanism. A borrower pays interest upfront in exchange for a lower stated rate over time. From the lender’s perspective, total yield is preserved.
The IRS does not view family loans through that lens.
For tax purposes, points paid on a family loan are treated as prepaid interest, not as a reduction of the interest rate. Prepaid interest is governed by the Original Issue Discount (OID) rules in Sections 1272 through 1275.
Those rules require that prepaid interest be:
- Included in the lender’s taxable income, and
- Amortized over the life of the loan as interest accrues.
In other words, paying points does not reduce the interest rate for IRS purposes. It merely accelerates when interest is recognized.
The IRS evaluates the economic yield of the loan, not the optics of the stated rate. If the total yield is less than the AFR, the loan is treated as below-market, and imputed interest generally applies.
For how imputed interest works in family mortgages–and how borrower deductibility is a separate analysis–see Imputed Interest and the Borrower’s Mortgage Interest Deduction.
Why a Rate Below AFR Still Triggers Imputed Interest
Consider a loan with a stated interest rate below the AFR where the borrower pays points upfront to “buy down” the rate.
Even if those points increase the lender’s overall return, the IRS still asks a single question: does the loan’s yield, calculated under the OID rules, meet or exceed the AFR?
If the answer is no, Section 7872 applies.
If the answer is yes, the structure becomes subject to OID accounting, annual accrual calculations, and careful income reporting. At that point, the loan may technically comply, but only by introducing complexity far beyond what most families or advisors intend.
What cannot happen is a simple reduction of the interest rate below AFR without tax consequences. The statute does not permit that outcome.
Theoretical Possibility, Practical Risk
In theory, it is possible to structure a loan with a stated rate below AFR if the prepaid interest, properly amortized, results in a yield that equals or exceeds AFR.
In practice, this approach carries significant drawbacks:
- It requires precise yield-to-maturity calculations.
- It triggers OID reporting obligations for the lender.
- It accelerates taxable income recognition.
- It increases audit risk, particularly where family relationships are involved.
- It undermines the simplicity and transparency that make intra-family loans effective planning tools.
For most families, the marginal benefit of a lower stated rate is outweighed by the administrative burden and tax exposure that accompany such structures.
The Clean Rule: Respect the AFR
The Internal Revenue Code provides a clear and reliable path for family lending:
Charge at least the Applicable Federal Rate that applies to the loan’s term at the time the loan is made.
Doing so avoids imputed interest, eliminates gift characterization, and allows the loan to be treated as a bona fide debt arrangement for tax purposes. No prepaid interest, no discount points, and no creative workarounds are required.
In the context of family lending, simplicity is not a limitation. It is the compliance mechanism.
Frequently Asked Questions
Can a borrower prepay interest on an intra-family loan to reduce the stated rate?
No. For tax purposes, prepaid interest is treated as interest income under the Original Issue Discount rules. It does not reduce the minimum interest rate required under Section 7872.
Are discount points allowed on family loans?
Points may be paid, but they are treated as prepaid interest, not as a pricing mechanism. They do not allow the stated interest rate to fall below the Applicable Federal Rate without triggering imputed interest rules.
Does the IRS look at the stated rate or the effective yield?
The IRS evaluates the economic yield of the loan. If the yield, calculated under the tax code’s interest and OID rules, is less than the AFR, the loan is treated as below-market.
What happens if a family loan is below the AFR?
The lender must report imputed interest income, and the borrower is treated as receiving a gift equal to the interest shortfall, even if no money changes hands.
Can a below-AFR loan ever be compliant?
Only in narrow circumstances involving detailed yield calculations and OID accounting. These structures are complex, increase reporting burdens, and are rarely appropriate for family lending.
What is the simplest way to avoid imputed interest on a family loan?
Charge at least the AFR that applies to the loan’s term at the time the loan is made and document the loan clearly.
Conclusion
Intra-family loans are powerful tools for helping family members purchase homes, transfer wealth, and plan across generations. But they operate within a tax framework that is intentionally rigid.
While paying points to buy down a mortgage rate works in the commercial lending world, it does not translate cleanly into family lending under Sections 7872 and 1274. The IRS focuses on economic yield, not nominal rates, and it treats prepaid interest as interest income–not as a discount.
For families and advisors seeking clarity, compliance, and long-term defensibility, the conclusion is straightforward:
You cannot safely buy down an intra-family loan rate below the AFR.
The correct solution is not creativity, but adherence to the rule the tax code already provides.
Technical Appendix
Relevant Statutory Framework
- IRC §7872 governs below-market loans between related parties and provides for imputed interest and gift treatment when a loan’s interest rate is below the Applicable Federal Rate.
- IRC §1274 addresses the determination of issue price and interest where debt instruments do not provide for adequate stated interest.
- IRC §§1272-1275 establish the Original Issue Discount (OID) rules, which govern the timing and recognition of prepaid or deferred interest. (IRC §1272, IRC §1273, IRC §1275)
Applicable Federal Rate (AFR)
The AFR is published monthly by the IRS and varies by loan term:
- Short-term: up to 3 years
- Mid-term: more than 3 years and up to 9 years
- Long-term: more than 9 years
The AFR in effect for the month the loan is made controls compliance for the life of the loan.
Original Issue Discount (OID)
OID arises when interest is paid or economically accrued in a manner that differs from the stated payment schedule. Prepaid interest, including points paid at origination, is treated as OID and must be amortized over the loan’s term using constant-yield methods.
OID does not reduce the required minimum interest rate under Section 7872.
Substance Over Form in Family Lending
For intra-family loans, the IRS evaluates substance over form. Any attempt to lower the interest rate below AFR through prepaid interest or points must still satisfy the yield requirements imposed by the tax code–and usually introduces more risk than benefit.
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.
© 2026 National Family Mortgage®, LLC. All rights reserved.