If you want to provide financial assistance to loved ones, you might consider making a loan rather than giving the money with no strings attached. However, it is critical to treat any transaction as a bona fide loan. The IRS reviews intrafamily loans and if it determines a loan is or includes a disguised gift, unwelcome tax consequences could follow.

Several advantages

Intrafamily loans offer several advantages over gifts. For one, they allow you to help family members without permanently parting with the money. And they can help instruct your children, grandchildren or other loved ones about financial responsibility.

Also, they may provide estate planning benefits. If borrowed funds produce returns that exceed the interest rate charged for the loan, the borrower essentially receives a tax-free gift.

Withstanding IRS scrutiny

To determine whether a transfer of funds is a loan or gift, the IRS and the courts generally examine several factors. Your transfer is more likely to be considered a loan if:

• The recipient has signed a promissory note;
• You have requested repayment when due (or the amount has already been repaid);
• You charge interest until a maturity date;
• The recipient has provided security or collateral;
• The recipient is likely to have the ability to repay;
• You and the recipient maintain records showing the transaction as a loan; and
• You and the recipient treat the transaction as a loan for federal tax purposes.

The interest rate you charge should be equal to or greater than the applicable federal rate (AFR) published by the IRS for the month you transfer the funds. If it is not, you may be subject to income tax on “imputed interest,” which is the excess of the AFR over the actual interest received. The result is “phantom income,” meaning you are taxed on income you never actually receive.

Charging adequate interest

Here is an example to illustrate the danger of charging interest below the AFR. Suppose you loan your son Ethan $300,000 for five years with an interest rate of 1.5% at a time when the mid-term (three to nine year) AFR is 5%. At the end of year one, Ethan pays you $4,500 in interest, but you are required to report $15,000 in interest on your tax return.

The difference between the amount of interest you received and the amount you would have received had you charged interest at the AFR — in this example, $10,500 — is phantom income. In addition, the amount of imputed income may be treated as a taxable gift to your son.

Additional potential consequences

If the stipulations are not met, the IRS could come in and recharacterize the intrafamily loan as a gift.  Depending on your net worth and the amount of the loan, this can trigger gift or estate taxes. For 2025, the gift and estate tax exemption is $13.99 million (or a combined $27.98 million for married couples).

Observe formalities

To ensure that an intrafamily loan is treated as such, be sure to observe the formalities associated with bona fide loans. Put it in writing, charge and collect adequate interest, require collateral if appropriate, and otherwise treat the transaction as you would a loan to a nonrelative.

For more information, contact Dan Newman at 312.670.7444 or [email protected]. Visit ORBA.com to learn more about our Wealth Management Services. Sign up here to receive our blogs, newsletters and Client Alerts.