How to Write a Loan Agreement Between Family Members

To write a loan agreement between family members, put the terms in a signed written document that names both parties, states the exact amount lent, sets an interest rate at or above the IRS Applicable Federal Rate, lays out a repayment schedule, and spells out what happens if a payment is missed. The written document is what separates a loan from a gift in the eyes of the IRS, and it is also what protects the relationship if memories later diverge about who owed what.

A verbal promise to repay gives the IRS no way to tell the transfer apart from a gift. If the agency treats it as a gift, the lender may owe gift tax on amounts exceeding the $19,000 annual exclusion for 2026, and the borrower loses any interest deduction that might otherwise apply.¹ A signed promissory note or loan agreement is the paper trail that prevents that outcome.

What the Document Needs to Contain

A family loan agreement does not have to be long, but several specific items need to be in it. Missing any of them creates confusion later or weakens enforceability.

Parties, Principal, and Date

Open with the full legal names and home addresses of the lender and the borrower. State the exact dollar amount in both words and numerals, for example “Ten Thousand Dollars ($10,000),” so a clerical error cannot be argued later. Include the effective date of the agreement and, if different, the date the funds will actually be transferred.

Interest Rate

Specify the annual interest rate. For most family loans this rate must meet or exceed the Applicable Federal Rate for the loan’s term, which is covered in the next section.

Repayment Schedule

Lay out exactly how the loan will be paid back: monthly installments, quarterly payments, or a lump sum on a specific date. Each scheduled payment should carry a dollar amount and a due date. State where payments are to be sent, whether that is a bank account for electronic transfers or a mailing address for checks.

Say explicitly whether the borrower may pay off the loan early. Without a prepayment clause, the borrower will not know whether early payoff is allowed or whether it triggers a penalty.

Default and Late Payments

Define what counts as a default. A grace period of 10 to 30 days before a missed payment is treated as late is common. After the grace period, the agreement can impose a flat late fee or a percentage of the overdue amount. An acceleration clause lets the lender demand the entire remaining balance if the borrower misses a set number of payments. These provisions give both sides a clear roadmap before anyone considers legal action.

Governing Law

If the lender and borrower live in different states, add a sentence stating which state’s laws govern the agreement. Parties typically choose the lender’s state or the state where the loan was executed.

Setting an Interest Rate the IRS Will Accept

Under 26 U.S.C. § 7872, a loan between family members must charge at least the Applicable Federal Rate (AFR), which the IRS publishes monthly. Charge less than the AFR, or nothing at all, and the IRS treats the gap between what you charged and what the AFR would have produced as a gift from the lender to the borrower.² That phantom gift can trigger a Form 709 gift tax return if combined gifts to the borrower pass the $19,000 annual exclusion.³

The AFR comes in three tiers, matched to how long the borrower has to repay:

Short-term, 3 years or less: 3.59% annually as of March 2026
Mid-term, over 3 years and up to 9 years: 3.93% annually as of March 2026
Long-term, over 9 years: 4.72% annually as of March 2026

These rates change monthly, and the current table is on the IRS’s Applicable Federal Rates page.⁴ The rate for a term loan is locked in on the date the loan is made, so a rate increase the following month does not affect the agreement.²

Small-Loan Exceptions

Two carve-outs can simplify smaller loans. Section 7872 does not apply at all to loans of $10,000 or less, so an interest-free loan at that size carries no gift-tax consequences, unless the borrower uses the money to buy income-producing assets such as stocks or rental property. For loans between $10,001 and $100,000, the imputed interest is capped at the borrower’s net investment income for the year, and if that income is $1,000 or less, it is treated as zero, meaning nothing is imputed at all.⁵ Above $100,000, the full AFR rules apply with no cap.

Adding Collateral

Collateral is not required, but pledging an asset gives the lender a way to recover the money if the borrower stops paying. The paperwork depends on the asset.

Real estate: the borrower signs a mortgage or deed of trust along with the promissory note, and the lender records it with the county recorder’s office, creating a lien. Recording fees vary by jurisdiction.
Vehicles: the lender is added to the title as a lienholder through the state motor vehicle agency. The lien is not enforceable against third parties until it appears on the title.
Other personal property: the lender files a UCC-1 financing statement with the state’s Secretary of State office, putting other creditors on notice of the claim.

Describe the asset in the loan agreement with enough detail to identify it: make, model, and VIN for a vehicle, or the address and legal description for real estate. State what happens to the collateral on default.

Signing, Witnessing, and Storing

Both parties must sign for the agreement to be binding. Sign in ink unless your state’s law specifically validates electronic signatures for promissory notes. Both signatures should appear on the same page, with each printed name beneath.

A disinterested witness, meaning someone with no financial stake in the loan, adds protection against later claims of forgery or coercion. Two witnesses are generally recommended, though requirements vary by state.

Notarization is not legally required in most states for a simple promissory note, but it creates an official record that both parties appeared and signed voluntarily. Notary fees are set by state law and typically range from a few dollars to $25 per signature.

Store the original in a secure place such as a fireproof safe or a bank safe-deposit box, and give each party a full copy of the signed and dated agreement. If the loan is secured by real estate, the recorded mortgage or deed of trust will also be on file with the county.

Taxes and Records to Keep After Signing

A family loan creates tax obligations on both sides. Interest the lender receives is taxable income and must be reported on the federal return, even though an individual borrower will not issue a Form 1099-INT. Report it on Schedule B of Form 1040.⁶

If the lender charges less than the AFR, the forgone interest is treated as a gift to the borrower.² When that imputed gift, combined with other gifts to the same person during the year, exceeds the $19,000 annual exclusion for 2026, Form 709 must be filed.⁷ Filing does not necessarily mean gift tax is owed; it reduces the lifetime exemption, which is $15,000,000 for 2026.⁸ Most family lenders will never owe actual gift tax, but the reporting requirement still applies.

If the lender later forgives part or all of the loan, the canceled amount is generally taxable income to the borrower, reported for the year of forgiveness. One exception matters: when the lender forgives the debt as a genuine gift, it is not cancellation-of-debt income to the borrower, and the gift rules apply to the lender instead.⁹

Keep a payment log with the signed agreement. For each payment, record the date, amount, and the split between principal and interest. Bank statements are useful backup, but a dedicated log is easier to review during an audit and keeps both sides aligned on the remaining balance. Hold onto the signed agreement, any amendments, and payment records for at least three years after the loan is fully repaid, which lines up with the general IRS audit window. If collateral is involved, keep the records until the lien is formally released.

One more scenario worth addressing in the agreement itself: what happens if the lender dies while the loan is outstanding. The unpaid balance becomes an asset of the lender’s estate, and the executor can continue collecting, renegotiate terms, or forgive the balance, which may carry gift or estate tax consequences. Stating in the agreement that the loan survives the lender’s death and transfers to the estate removes uncertainty for the family left behind.

1
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026, Including Amendments From the One, Big, Beautiful Bill
2
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
3
Internal Revenue Service. Instructions for Form 709 (2025)
4
Internal Revenue Service. Applicable Federal Rates (AFRs) Rulings
5
Office of the Law Revision Counsel. 26 US Code 7872 – Treatment of Loans With Below-Market Interest Rates
6
Internal Revenue Service. Topic No. 403, Interest Received
7
Internal Revenue Service. Gifts and Inheritances 1
8
Internal Revenue Service. What’s New – Estate and Gift Tax
9
Internal Revenue Service. Topic No. 431, Canceled Debt – Is It Taxable or Not?