A Family Loan Agreement is a written contract that formalizes a lending arrangement between family members, establishing the same legal terms, rights, and obligations that would exist in a commercial loan. Under IRC Section 7872, the IRS treats below-market loans between family members as constructive gifts subject to gift tax unless the loan charges interest at or above the Applicable Federal Rate (AFR) published monthly by the IRS under IRC Section 1274(d). Failure to document the loan properly may result in the IRS reclassifying the entire principal as a gift, potentially triggering gift tax liability and consuming the lender's lifetime exemption.

The legal enforceability of intrafamily loans depends on demonstrating that the transaction is a bona fide debt obligation rather than a disguised gift. Courts examine several factors established in Estate of Van Anda v. Commissioner (12 T.C. 1158, 1949) and subsequent cases: existence of a written promissory note, fixed repayment schedule, adequate interest rate, actual payment history, collateral or security, and consequences for default. A handshake loan between parent and child, with no documentation, sporadic repayments, and no interest, will almost certainly be recharacterized as a gift.

Family loan agreements also serve the critical function of preserving family relationships by establishing clear expectations. The terms are agreed upon at the outset rather than assumed, and both parties understand exactly when payments are due, what interest applies, and what happens if the borrower encounters financial difficulty.

A parent lending $50,000 to an adult child for a home down payment needs a family loan agreement that charges at least the AFR (which fluctuates monthly; for example, the mid-term AFR might be 4.5% for a 3-9 year loan term). The agreement documents the loan as a bona fide debt, allowing the parent to report interest income while the child may deduct mortgage interest if the loan is properly secured by the residence under IRC Section 163(h).

Siblings who jointly inherited a property where one sibling wants to buy out the other's share use a family loan when the purchasing sibling cannot obtain full bank financing. The agreement specifies the buyout price, interest rate, repayment term, and the property as collateral through a deed of trust or mortgage recorded against the title.

Grandparents funding a grandchild's college education as a loan rather than a gift can preserve the annual gift tax exclusion ($18,000 per recipient in 2024) for other transfers. The loan agreement establishes repayment beginning after graduation with a deferment period for the duration of schooling.

Family members investing in a relative's startup business should document the investment as a loan with defined repayment terms rather than an informal arrangement. If the business fails, a properly documented loan creates a deductible non-business bad debt under IRC Section 166(d), treated as a short-term capital loss. Without documentation, the IRS will deny the deduction on the grounds that no bona fide debt existed.

The promissory note must identify the lender and borrower by full legal name and relationship, state the principal amount, and reference the loan agreement for detailed terms. The interest rate must meet or exceed the AFR for the applicable loan term: short-term (up to 3 years), mid-term (3-9 years), or long-term (over 9 years). The specific AFR in effect on the date of the loan should be referenced. Under IRC Section 7872(c)(2), loans of $10,000 or less between individuals are exempt from the imputed interest rules, provided the loan is not directly attributable to the purchase of income-producing assets.

The repayment schedule must specify exact payment amounts, due dates, and the amortization method (equal installments, interest-only with balloon, or graduated payments). The schedule should be realistic and consistent with the borrower's actual ability to repay. Courts scrutinize family loans where no payments were ever made as evidence of gift intent rather than genuine debt.

Default provisions should define what constitutes default (missed payments, bankruptcy filing, death of borrower), the cure period allowed, and the remedies available to the lender. Late payment penalties should be reasonable. Acceleration clauses allowing the lender to demand full repayment upon default provide enforcement leverage.

Security provisions should address whether the loan is unsecured or secured by collateral such as real property (requiring a recorded mortgage or deed of trust), vehicles (requiring a lien notation on the title), or other assets. The tax reporting section should note that the lender must report interest income on Schedule B of Form 1040, and if applicable, the borrower may deduct interest on Schedule A or Schedule C. Both parties should sign, date, and retain copies of the agreement.