What’s the Safest Way to Lend Money to a Relative?

 

How Families Can Reduce Tax, Legal, and Relationship Risk When Lending Money

 

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

 

Executive Summary

Lending money to a relative can be an effective way to provide financial support while preserving family assets and expectations. From a federal tax and risk-management perspective, however, informal arrangements create disproportionate exposure. The most common problems arise when a transfer intended as a loan is later treated as a gift, when interest is charged below required levels, or when repayment expectations are unclear or unenforced.

The safest way to lend money to a relative is to structure the transaction as bona fide debt from the outset: clearly documented, properly priced, and supported by conduct consistent with a real creditor-debtor relationship. When lending is connected to a home purchase or refinance, additional considerations apply, including secured documentation and alignment with mortgage-interest rules.

This article outlines the core elements that reduce tax risk, legal ambiguity, and family conflict when relatives choose to lend money to one another.

 

Why Informal Family Loans Create Risk

Families often rely on trust and shared understanding rather than formal documentation. While that approach may feel appropriate in personal relationships, it creates problems when viewed through a tax or legal lens.

Common risk points include:

• Unclear or unenforceable repayment terms

• No stated interest, or interest charged below required levels

• Lack of written documentation

• Inconsistent or nonexistent repayment behavior

• Later disputes about whether repayment was ever expected

When these factors are present, the IRS and courts may treat the transfer as a gift rather than a loan, regardless of how the family describes it.

 

The Safest Structure: Bona Fide Debt

From a tax and risk perspective, the safest way to lend money to a relative is to ensure the transaction reflects the substance of real debt.

Core elements of a defensible family loan

A family loan is more likely to be respected when it includes:

• A written promissory note stating:

  • Principal amount

  • Interest rate

  • Repayment schedule

  • Maturity date

• Stated interest at an adequate rate, commonly evaluated by reference to Applicable Federal Rates (AFRs)

• Objective evidence of repayment, such as regular payments and records

• Conduct consistent with enforcement, even when flexibility is exercised

No single factor controls the outcome. Instead, the overall facts and circumstances determine whether a loan reflects bona fide debt or a disguised transfer of wealth.

 

Why Interest Rates Matter

Loans that charge no interest–or interest below required benchmarks–may trigger the imputed interest rules even when no cash interest is paid.

 

Applicable Federal Rates (AFRs)

Applicable Federal Rates (“AFRs”) are the minimum interest rates published monthly by the Internal Revenue Service and referenced in the tax code as benchmarks for evaluating whether stated loan interest is adequate. 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.

Failing to address interest properly can result in tax consequences even if no cash interest changes hands.

 

Documentation Is Not About Distrust

A frequent objection to formal documentation is that it feels unnecessary–or even uncomfortable–within a family. In practice, documentation often serves the opposite function.

Clear loan terms help:

• Set expectations at the outset

• Reduce misunderstandings over time

• Protect both lender and borrower

• Preserve family relationships if circumstances change

Documentation is not about enforcing harsh outcomes; it is about clarity and predictability.

 

Lending for a Home Purchase or Refinance

When a relative lends money for a home purchase or refinance, additional considerations apply.

Secured vs. unsecured loans

A loan does not have to be secured to exist. However, when the loan is intended to function as a mortgage–and when mortgage-interest treatment is relevant–properly executed and recorded lien documentation is typically required.

Failing to record a lien may not invalidate the loan, but it can affect:

• Tax treatment

• Priority among creditors

• Risk exposure if circumstances change

 

Flexibility, Modifications, and Enforcement

Families often want flexibility if a borrower experiences financial difficulty. Flexibility is not inconsistent with a bona fide loan–but it should be handled thoughtfully.

Key points:

• Changes to loan terms should be documented

• Temporary forbearance is different from permanent forgiveness

• Forgiving debt generally constitutes a transfer of value at the time of forgiveness, not at loan inception

Treating modifications casually increases the risk that the original loan will be recharacterized.

 

Judicial Perspective: Expectation and Enforcement

Courts analyzing family loans consistently emphasize two related concepts:

1. A realistic expectation of repayment, and

2. An intent to enforce repayment

These principles appear repeatedly in tax court decisions addressing whether advances between family members constitute loans or gifts. Labels alone are not determinative; conduct and documentation carry greater weight.

For another common profile with distinctive income timing challenges, see Intra-Family Mortgages for Medical Residents and Fellows.

Frequently Asked Questions

Is a written agreement really necessary when lending to family?
While not legally required in every case, written documentation provides objective evidence that a transaction is a loan and not a gift. It significantly reduces ambiguity and risk.

Can a family loan charge a very low interest rate?
Interest must meet minimum standards to avoid below-market loan treatment. AFR-based rates are commonly used to address this requirement.

What happens if the borrower stops making payments?
Failure to enforce repayment may undermine the loan’s treatment as bona fide debt. Flexibility can be appropriate, but it should be documented and consistent with creditor behavior.

Is it safer to make a gift instead of a loan?
Gifts may be simpler in some situations, but they have different tax and planning implications. Loans and gifts serve different purposes and should not be confused.

Does a family loan need to be recorded when it involves a home?
Recording a lien is generally required for a loan to function as a mortgage and for certain tax treatments to apply.

 

Common Misunderstandings

“Because we’re family, documentation doesn’t matter.”
From a tax perspective, documentation often matters more in family transactions than in arm’s-length ones.

“If no interest is charged, it’s still clearly a loan.”
Below-market interest can trigger imputed-interest and gift consequences even when repayment is expected.

“We can decide later whether it was a loan or a gift.”
Ambiguity increases risk. Classification is determined based on facts and intent at the time funds are advanced.

 

Technical Appendix

Key concepts
Bona fide debt
Below-market loans and imputed interest
AFR-based interest benchmarking
Debt forgiveness as a transfer of value

Judicial framework
Expectation of repayment
Intent to enforce repayment

 

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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