Wealth Planning With Intra-family Loans

Tax News You Can Use | For Professional Advisors

October 13, 2025

Estate planners often focus on how to give property, outright or in trust, to the donor’s chosen beneficiaries. And lifetime gifts, particularly those that qualify for the gift tax annual exclusion or the marital or charitable deduction, as well as those which fall within the donor’s applicable exclusion amount ($13.99 million in 2025, and $15 million in 2026), are important ways to manage a taxpayer’s ultimate transfer tax obligations. However, lending can be another way to transfer wealth. There can be income, gift, estate and even generation-skipping transfer (GST) tax consequences to low- or no-interest loans, though, so understanding the IRS rules is important.

Below-market Loans

Loans between unrelated parties under arm’s length conditions can bear interest at the rate agreed to by the parties, including 0% (as seen in various car ads). However, where the parties are connected, the tax code requires the loan to bear a minimum rate of interest (the applicable federal rate, or AFR, computed under section 1245 of the Internal Revenue Code). A loan at an interest rate lower than the AFR will be deemed to bear interest at the AFR. In that event, the lender recognizes phantom income in the amount of the foregone interest. The lender is also treated as having transferred to the borrower the funds to pay the phantom interest, which can have income and/or transfer tax implications depending on the relationship between the parties. The tax code requires the following types of loans to bear interest at the AFR under IRC §7872:

• Loans between family members.¹
• Loans between trusts, or between trusts and grantors or beneficiaries.
• Loans from a business to a shareholder.
• Loans to an employee/independent contractor.
• Certain other tax avoidance loans.

For loans between individuals, the lender is treated as making a gift to the borrower and then receiving payment of interest, causing both income and gift tax issues. Where it is between an employer and an employee, the phantom income to the lender is also compensation to the borrower, and where it is between a company and a shareholder, there is phantom dividend income to the shareholder on top of the phantom interest income to the lender.

For loans between individuals, there are two exceptions. First, there is a de minimis rule for loans under $10,000. Second, where the aggregate amount of loans between two individuals is less than $100,000, the annual imputed interest is limited to the amount of the borrower’s net investment income. Below-market loans between individuals are commonly referred to as gift loans.

What Is The AFR?

Every month the IRS publishes tables with the AFRs.² There are rates for less than three years (the short-term AFR), for loans between three and nine years (the mid-term AFR), and for loans for more than nine years (the long-term AFR). For each duration, the published table has adjustments for interest compounded annually, semi-annually, quarterly, and monthly.

Where the loan has a stated duration or term (referred to as a term loan), determining the required rate of interest to avoid tax on phantom interest is done by selecting the rate from the table for the month in which the loan is made. If the loan bears interest at the AFR in effect at the time it is made, it is not impacted by a change in the AFR for a later period. The lender knows upfront whether there will be imputed income or gifts. The following table shows the AFRs³ for August, September, and October of 2025 assuming semi-annual compounding.

Notes without a maturity date, considered payable on demand of the lender and referred to as demand loans, are treated as bearing interest at adjustable rates that reset twice per year. The rate is based on the short-term AFR for semiannual compounding, prorated for the days outstanding. The IRS publishes a blended rate for demand notes outstanding for an entire year. Demand loans bear a similar risk of interest rate fluctuation to commercial adjustable-rate loans. Demand notes seem simple, but they are complex from a tax compliance perspective. If a demand note specifies a fixed interest rate, the loan may be AFR-compliant when made but cause imputed transfers/income in a later period when the AFR changes, causing deemed income and/or gifts. The following table shows the semi-annual AFRs for January and December and the blended rate for loans outstanding for a full year for the past three years:

When To Consider Loans For Wealth Planning

Why would related parties use loans rather than other transfers (outright gifts, dividends or compensation)? Sometimes, the reason is simply that making a gift or paying compensation or dividends would be too costly from a tax perspective for one of the parties. Often it is a way to shift liquidity from one person or entity to another. Sometimes it is because, from the borrower’s perspective, AFR rates are typically less than commercially available interest rates. Borrowing from a family member at the AFR can result in lower interest payments. In addition, paying interest to a family member may be more appealing than paying it to a third party.

From the lender’s perspective, a loan at the AFR may provide a higher rate of return than a money-market investment. Intra-family loans can provide income tax deductions for mortgage or investment interest paid if the loan proceeds are used for a deductible purpose. It can be a way to provide a benefit to a beneficiary at a lower tax cost (gift or income). Intra-family loans also play an important role in estate freezes, such as when a trust buys appreciating assets from the grantor in exchange for the trust’s note. In such cases, the appreciation on the assets is shifted to the trust (outside the estate), and the grantor’s estate retains only the note payable with a fixed interest payment, but no appreciation rights.

It is often the basis for a split-dollar insurance arrangement in the employment and shareholder contexts.

Computing Phantom Interest For Tax Purposes

A related-party note that bears no interest or has an interest rate lower than the AFR is treated as though the loan were at the AFR. There is then a computation of phantom interest, which is interest calculated using the AFR, reduced by the amount of interest actually paid. The parties are taxed as though the lender had transferred funds to the borrower who then paid interest to the lender. In a gift loan between individuals, the lender is deemed to make a gift to the borrower of the phantom interest, and the borrower is deemed to pay the lender the phantom interest. This results in a gift from the lender that may generate a gift and a GST tax. For loans to employees at below market rates, the employer is deemed to pay compensation to the employee and the employee is deemed to pay that interest back to the employer. If a trust makes a loan below the AFR to a beneficiary, it is deemed to make a distribution to the beneficiary, which will carry out DNI. In each case, the lender receives deemed income that is taxable.

Example 1 – Term Loan:

In September 2025, Maria loans $1,000,000 to her son, Seth, at 2% interest for three years for his living expenses until a trust pays out to him at age 30.

• Annual imputed interest at the short-term AFR would be $40,000 (interest at 4%) minus $20,000 (interest paid at 2%) for each full year outstanding.
• Each year, Maria is treated as making a deemed gift to Seth of $20,000 (the deemed or phantom interest).
• Maria has deemed income of $20,000 in addition to $20,000 actual income.
• The interest (both paid and deemed) is personal interest and may not be deducted by Seth.

Example 2 – Demand Loan:

On September 1, 2025, Martin loaned $1,000,000 to his daughter, Diane, with an unsecured note bearing no interest and payable on demand. Diane uses this money to buy a condominium in Miami. Because the unsecured note is not a mortgage, the interest on this loan is not deductible by Diane.

• The imputed gift by Martin and the imputed income to Diane for 2025 is calculated using the July semiannual short-term AFR of 4.08%, adjusted for a short year of 122 days.
• For the short year of September through December, $1,000,000 X 4.08% X 122/365 = $13,637.26.
• The rate resets in January and every six months after that.

Estate Tax Considerations

When one of the parties to an intra-family loan dies, the value of the loan as an asset or a deduction in the decedent’s estate arises. If the loan has gone unpaid for a long period, if the statute of limitations for collecting the loan has passed without an effort by the decedent to collect, or if the borrower was or is now insolvent, the IRS may argue that the loan was really a gift at the time funds were disbursed. The value of the loan as an asset of the estate may be challenged if it would be worth more at the time of death due to market conditions.

Two recent cases have established rules for valuing notes in the estate of the deceased lender. In the Estate of Mary Bolles v. Commissioner, T.C. Memo 2020-71, affirmed, No. 22-70192 (9th Cir., 2024), the court found that gift or loan treatment depends on whether there was a realistic expectation of repayment. In this case, loans made between 1985 and1989 were bona fide loans. However, once the borrower’s circumstances changed and the decedent learned of her son’s inability to repay her, subsequent transfers were gifts and not loans. In Estate of Galli v. Commissioner, T.C., No. 7003-20 and 7005-20 (2025), the Tax Court found that where the parties documented transactions as loans, observed formalities, paid interest, and included it in income, there was no gift. The note was valued at unpaid principal for estate tax purposes in the estate of the lender. No gift tax return was filed by lender at the time of the transfer. The court agreed with the taxpayer that not filing a gift tax return supported the estate’s position that the decedent did not intend to make a gift but intended to make a loan.

Fiduciary Duties For Loans Made By Trustees

Intra-family loans include loans between trusts and beneficiaries or entities owned by them, or loans from grantors or beneficiaries to trusts. Loans may shift liquidity to where it is needed, avoid GST tax on a distribution, or facilitate an estate freeze. Trustees are subject to fiduciary duties owed to beneficiaries of the trust and must evaluate proposed loans subject to these duties. This includes the initial terms and the terms of any refinancing. The terms of the trust may specifically permit or prohibit certain loans or waive conflicts of interest. Typically, trustees loan funds to beneficiaries only for purposes authorized by the trust for loans or distributions.