What’s the Difference Between a Family Loan and a Gift?

 

How the IRS Distinguishes Bona Fide Debt from a Transfer of Wealth

 

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

 

This article explains how family transfers are classified for tax purposes; for practical steps families use to avoid disputes and misunderstandings, see Loan vs. Gift: How to Avoid Tax Issues and Family Misunderstandings.

 

Executive Summary

Families frequently transfer money to help with a home purchase, refinance, renovations, or other major expenses. From a federal tax perspective, the outcome depends on whether the transfer is treated as a bona fide loan–real debt with a genuine obligation to repay–or a gift, meaning a transfer of wealth made without receiving something of at least equal value in return.

A family loan is generally respected when it reflects the economic substance of real debt: a written note, defined repayment terms, stated interest, and–when the transaction involves a home–documentation consistent with secured mortgage lending. A gift, by contrast, is typically characterized by the absence of a real repayment obligation, even if the parties informally refer to the arrangement as a “loan.”

The most common reasons family loans encounter tax problems are (1) charging below-market or no interest, triggering the below-market loan and imputed-interest rules, and (2) failing to establish or maintain objective evidence of intent to repay and intent to enforce repayment.

 

The Core Distinction: Repayment Obligation vs. Transfer of Wealth

A family loan (bona fide debt)

A family loan creates a creditor-debtor relationship. The lender expects repayment, and the borrower is legally obligated to repay under defined terms. In practice, arrangements treated as bona fide debt commonly include:

  • A written promissory note stating principal, interest rate, maturity date, and payment terms

  • A repayment schedule and records showing payments are actually made

  • Stated interest at an adequate rate, commonly evaluated by reference to Applicable Federal Rates (AFRs) in intra-family lending

  • When the loan relates to a home and mortgage-interest treatment is relevant, a properly executed and recorded lien instrument (mortgage, deed of trust, or security deed), consistent with state law

Family lenders may choose to be flexible, but flexibility is far more defensible when it is documented in a manner consistent with how an unrelated lender would document changes to loan terms.

A gift

For federal tax purposes, a gift generally occurs when money or property is transferred and the transferor does not receive something of at least equal value in return, regardless of how the parties describe the transaction.

In family contexts, transfers are more likely to be treated as gifts when:

  • There is no realistic expectation of repayment

  • Repayment is indefinite or optional (“pay us back when you can”)

  • There is no meaningful enforcement of repayment terms

  • The arrangement charges no interest or below-market interest without complying with the below-market loan rules

 

Why Intent Alone Is Not Enough

Families often assume that shared understanding makes a transfer a loan. In examinations and disputes, however, the IRS and courts emphasize objective evidence over stated intent.

Factors commonly examined include:

  • Whether a written note exists

  • Whether there is a fixed maturity date

  • Whether interest and payment terms are stated

  • Whether payments are actually made

  • Whether the lender’s conduct reflects an intent to enforce repayment

No single factor is determinative. Taken together, however, these indicators help distinguish bona fide debt from informal family assistance.

 

Judicial Guidance: Miller v. Commissioner

Courts frequently cite Miller v. Commissioner when analyzing whether advances between family members constitute loans or gifts. In Miller, the Tax Court emphasized the importance of a realistic expectation of repayment and an intent to enforce repayment at the time funds are advanced.

Subsequent cases applying Miller reinforce a consistent theme: labels are not controlling. Documentation, conduct, and economic reality carry greater weight than how family members describe the transaction.

 

Interest Rates, Below-Market Loans, and Imputed Interest

Even when repayment is expected, charging too little–or no–interest can create separate tax consequences.

The below-market loan framework

Internal Revenue Code §7872 addresses loans that charge no interest or less than a required minimum rate. In simplified terms, certain below-market loans may be treated as though:

  1. Interest were charged at a government-defined benchmark rate, and

  2. That interest amount were effectively transferred back to the borrower, often analyzed as a deemed transfer of value

This mechanism is commonly referred to as imputed interest. While it does not automatically convert a loan into a gift, it can result in taxable consequences even when no cash interest changes hands.

Why AFRs matter in family lending

Applicable Federal Rates (“AFRs”) are the minimum interest rates published monthly by the Internal Revenue Service for federal tax purposes, and they serve as benchmarks in the Internal Revenue Code to evaluate whether a loan’s stated interest is adequate for income and gift tax analysis. Using an AFR-based rate is a common method for aligning a family loan with federal expectations and reducing the risk of imputed-interest and gift-characterization issues.

 

Gifts, Reporting, and Loan Forgiveness

Gifts may require reporting on a federal gift tax return depending on their size and structure, even though many taxpayers will not owe gift tax due to available exclusions and exemptions. Current annual limits and lifetime thresholds are published by the IRS and should be confirmed at the time of any transfer.

A frequent point of confusion arises when a transfer begins as a loan but is later forgiven. Debt forgiveness is generally treated as a transfer of value at the time forgiveness occurs, rather than as part of the original loan transaction.

 

Family Loans Used to Purchase or Refinance a Home

When funds are advanced to purchase or refinance a home, families often focus on two objectives:

  1. Preserving treatment as bona fide debt rather than a disguised gift, and

  2. Maintaining eligibility for mortgage-interest treatment when the applicable rules are met

In these situations, clean documentation and–where appropriate–a properly executed and recorded lien instrument are critical. An informal “family mortgage” without a recorded security instrument may function economically like a loan but fail to satisfy the technical requirements associated with secured home debt.

 

Frequently Asked Questions

How does the IRS decide whether money from a family member is a loan or a gift?
The IRS and courts generally examine whether there was a real expectation of repayment and an intent to enforce repayment, supported by documentation, stated terms, and actual payment behavior.

Can a family loan charge no interest?
A loan can exist without stated interest, but charging no or below-market interest can trigger the below-market loan rules and imputed-interest consequences under Internal Revenue Code §7872.

If a family loan is later forgiven, what are the tax consequences?
Loan forgiveness is generally treated as a transfer of value at the time forgiveness occurs and may be analyzed as a gift depending on the facts and amounts involved.

Does a family loan have to be secured by the home to be respected?
A loan does not have to be secured to exist. However, when the transaction involves home financing and mortgage-interest treatment is relevant, a properly executed and recorded lien is typically required.

Is written documentation really necessary if everyone agrees it is a loan?
While intent matters, written documentation and consistent conduct provide objective evidence that an advance is bona fide debt rather than a disguised gift.

 

Common Misunderstandings

“If we charge 0% interest, it’s still a loan.”
A loan can exist, but below-market interest may trigger imputed-interest and deemed-transfer consequences.

“If everyone agrees it’s a loan, the IRS must respect it.”
Courts and the IRS focus on objective evidence and conduct, not just intent.

“We can decide later whether it was a loan or a gift.”
Ambiguity generally increases risk. Later forgiveness often results in gifts at the time forgiveness occurs.

 

Technical Appendix

Statutory authority
Internal Revenue Code §7872 (below-market loans)

Judicial authority
Miller v. Commissioner, T.C. Memo 1996-3, and subsequent cases addressing intent to repay and intent to enforce

Key concepts
Bona fide debt vs. gift characterization
Imputed interest mechanics
AFR-based interest benchmarking
Debt forgiveness as a transfer of value

 

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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