Make a Personal Loan to a Relative or Friend? Here’s What you Need to Know.

If your adult child or a close friend needs financial help — maybe to buy their first home or cover a temporary shortfall — you might consider offering a personal loan. It's a generous move, but before handing over the money, you should be aware of some important tax implications.

Put the Personal Loan in Writing

To avoid future complications, document the loan with a written agreement. This ensures that it’s treated as a loan, not a gift, which becomes especially important if the borrower can’t repay you.

If the loan goes bad, you may be able to claim a “non-business bad debt” deduction. This deduction is treated as a short-term capital loss on your federal income tax return. You can use that loss to:

• Offset short-term capital gains (typically taxed at higher rates),

• Offset long-term capital gains, and then

• Offset up to $3,000 of ordinary income each year ($1,500 if you file separately).

What to Include in the Loan Agreement

To meet IRS standards and protect yourself, the loan should be backed up by a promissory note that spells out:

• The interest rate (if any),

• A repayment schedule with due dates for both interest and principal, and

• Any collateral or security backing the loan.

Use the Right Interest Rate

The IRS sets Applicable Federal Rates (AFRs) each month. These are the minimum interest rates you can charge without triggering unintended tax consequences. The AFR you use depends on the loan’s term. For April 2025, the monthly compounded AFRs are:

• Short-term (3 years or less): 4.09%

• Mid-term (more than 3 but not more than 9 years): 4.13%

• Long-term (more than 9 years): 4.52%

Example:Let’s say in April 2025, you lend your daughter $105,000 for her first home with an eight-year repayment term. If you charge the mid-term AFR of 4.13% with monthly compounding, you’re in the clear. It's a great deal for her — better than what a bank might offer — and it meets IRS requirements.

Why AFR Matters

As long as your loan charges at minimum, the AFR, tax reporting will be straightforward. You should report the interest you receive as income on your Form 1040. And if the loan is secured by the home, your borrower might be able to deduct the interest as mortgage interest.

Say you charge less than the AFR. What happens then? The IRS will consider the difference as an imputed gift. Here’s how that works:

• You’re treated as having given the borrower the difference between the AFR and the actual interest charged.

• Then, you’re also considered to have received that amount back as “phantom interest income”.

• You must report that imputed phantom interest income on your tax return — even though you didn’t actually receive it.

There are a couple of exceptions to these imputed interest rules, but they’re specific. If you’re considering a below-market loan, it’s best to talk to a tax advisor to see if you qualify for one of these exceptions.

Final Thoughts

Lending money to someone you care about can be a real lifeline — but don’t skip the planning. A simple loan agreement and the right interest rate can go a long way in protecting both your finances and your relationship.

If you’re unsure how to structure the loan or want to explore tax-saving strategies, reach out to us for guidance.