Intra-Family Loans and the AFR: Lending to Your Children the Right Way

An intra-family loan lets you lend money to a child or other family member at the IRS-published applicable federal rate (AFR), which is usually well below commercial lending rates. For June 2026, the AFRs are 3.85% short-term, 4.13% mid-term, and 4.87% long-term with annual compounding, per Rev. Rul. 2026-11. If the loan charges at least the AFR, is properly documented, and is actually repaid, no gift occurs and no interest is imputed under Section 7872.

That single paragraph contains the whole recipe. The rest of this article explains why each ingredient matters, what happens when families skip one, and how loans compare with outright gifts and more advanced transfer techniques.

Why would a family use a loan instead of a gift?

A loan moves opportunity, not wealth. The borrower gets capital today, perhaps to buy a home, fund a business, or refinance expensive debt, and the lender keeps a right to repayment. Because nothing is given away, the loan uses none of the lender's $15 million federal gift and estate tax exemption and none of the $19,000 annual gift exclusion that applies per recipient in 2026 (IRS inflation adjustments for 2026).

The economic appeal is the rate spread. If a child borrows $1 million from a parent at the long-term AFR of 4.87% instead of a 6.5% jumbo mortgage, the child saves roughly $16,300 in interest in the first year alone, and that saving compounds. Any growth the borrowed capital earns above the AFR stays with the child, outside the parent's taxable estate.

Loans also preserve flexibility. A parent who is unsure whether a transfer should be permanent can start with a loan and later forgive it deliberately, rather than making an irrevocable gift on day one.

What does Section 7872 require?

Section 7872 of the Internal Revenue Code governs below-market loans between family members. If you charge less than the AFR, the law treats the foregone interest as if it happened anyway: the lender is deemed to have made a gift of the missing interest to the borrower, and the lender generally must recognize that phantom interest as taxable income. In other words, charging zero interest does not avoid tax; it creates imputed interest plus a deemed gift.

The correct AFR depends on the loan's term at origination. Loans of three years or less use the short-term rate, loans over three and up to nine years use the mid-term rate, and loans longer than nine years use the long-term rate. The rate is locked in for the life of a term loan, which is why many families prefer to set long-term loans when rates are low, and why demand loans (repayable on request) are riskier: their rate floats with the AFR each period.

Two statutory exceptions soften the rules at small dollar amounts. Loans of $10,000 or less between individuals are generally exempt, and for loans of $100,000 or less, imputed interest income to the lender is capped at the borrower's net investment income (treated as zero if that income is $1,000 or less). Both exceptions have anti-abuse conditions, so they are conveniences, not planning platforms.

How should an intra-family loan be documented?

The IRS and the courts look at substance. A transfer labeled a loan can be recharacterized as a gift if it does not behave like real debt. The pattern that holds up includes:

• A signed promissory note stating principal, the AFR-based rate, payment schedule, and maturity date.
• Actual payments made on schedule, ideally by traceable transfers, with records kept by both parties.
• Security where appropriate. A recorded mortgage on a home loan also lets the borrower deduct the interest as qualified residence interest, subject to the usual limits.
• A borrower with a realistic ability to repay, and a lender who enforces the note or formally modifies it if circumstances change.
• Interest income reported on the lender's tax return.

Missing documents and ignored payment schedules are the most common reasons family loans fail on audit. Treat the loan with the same formality a bank would.

Can I forgive the loan over time?

Yes, with care. A lender may forgive principal or interest each year, and forgiveness is a gift in the year it occurs. In 2026 a parent can forgive up to $19,000 per borrower ($38,000 for a married couple electing to split gifts) within the annual exclusion, with larger forgiveness drawing on the $15 million lifetime exemption.

The trap is prearrangement. If the evidence suggests the parties never intended repayment, for example forgiveness scheduled from the outset with no payments ever made, the IRS can argue the entire original transfer was a gift on day one. Make the loan real first; decide on forgiveness year by year as an independent choice, and document each forgiveness in writing.

A hypothetical example with numbers

Hypothetical: in June 2026, parents lend a daughter $2,000,000 for nine years at the mid-term AFR of 4.13%, interest-only with a balloon repayment, documented by a note. The daughter invests the proceeds in a diversified portfolio.

She owes $82,600 of interest each year, which the parents report as taxable income. If her portfolio earns 7% annually (purely illustrative, not a projection), it grows to roughly $3.68 million over nine years while she pays about $743,000 of cumulative interest and repays the $2 million principal. Roughly $940,000 of value ends up with the daughter with no gift tax consequence, because she simply out-earned a rate the tax law itself blesses. If markets instead return less than 4.13%, the strategy loses money for her, which is the honest risk disclosure every family should hear.

How do loans compare with gifts and grantor trust sales?

A loan keeps the asset (the note) in your estate; only the excess growth shifts. An outright gift removes the asset and all future growth but consumes exemption. For families pursuing larger freezes, lending or selling assets to an intentionally defective grantor trust combines the AFR mechanics described here with trust-based leverage; we cover how IDGTs, GRATs, and related vehicles work in The Trusts Wealthy Families Actually Use, and the exemption context in The $15 Million Estate Tax Exemption. The right tool depends on asset growth expectations, the lender's income tax tolerance, and how permanent the transfer should be.

Key numbers for June 2026

Frequently asked questions

What is the minimum interest rate for a family loan in 2026?The applicable federal rate for the month the loan is made and for its term length. In June 2026 that is 3.85% short-term, 4.13% mid-term, or 4.87% long-term, compounded annually, per Rev. Rul. 2026-11.

Do I pay tax on interest my child pays me?Yes. Interest received on a family loan is ordinary taxable income to the lender, just like interest from any other borrower.

Can I just charge zero interest?Not without consequences above the small-loan exceptions. Section 7872 imputes the foregone interest as income to you and treats it as a gift to the borrower.

Is a family loan reported to the IRS when made?The loan itself is not separately filed, but the lender reports interest income annually, and any forgiveness above the annual exclusion requires a gift tax return (Form 709).

What happens to the loan if the lender dies?The outstanding note is an asset of the lender's estate at its remaining value. Some families address this with note terms, life insurance, or bequest provisions; it should be coordinated with the overall estate plan.

Can the borrower deduct the interest?Only if the interest qualifies under normal rules, for example as qualified residence interest on a properly secured and recorded home loan, or as investment interest subject to its limits. Personal-purpose interest is not deductible.