Housing prices have pushed a lot of today’s younger buyers out of the conventional mortgage market. Parents have an understandable instinct to help out, but will often transfer a lump sum to their kids to go toward the down payment.

The problem is, informal cash transfers come with tax consequences. Structuring that helping hand as a formal loan instead of a gift protects your capital, satisfies the IRS, and reduces the risk of family conflicts down the road.

Quick Answer: How to Structure the ‘Bank of Mom and Dad’

A loan between family members must charge interest at or above the IRS Applicable Federal Rate to avoid being reclassified as a taxable gift. The loan must be documented with a legally enforceable promissory note that includes the principal, interest rate, and repayment schedule. Both parties have tax reporting obligations once the loan is in place. If the cash transfer is informal with no documentation, it’s treated by the IRS as a gift, with consequences for both the giver and the recipient.

The Details: The Gift Tax Trap

Transferring money to your child for a down payment without a formal structure means the IRS considers it a “gift.” Each donor can give each recipient up to the annual gift tax exclusion ($19,000 per person in 2025) without filing a return.

Transfers above that amount require you to file Form 709, a gift tax return, and the excess counts against your lifetime estate and gift tax exemption.

For large down payment contributions, that exposure adds up faster than most parents expect.

Here’s what you can do to avoid gift taxes in cases like these:

The IRS Solution: The Applicable Federal Rate

IRC Section 7872 governs below-market loans between related parties. To avoid gift tax reclassification, a family loan must charge at least the IRS Applicable Federal Rate (AFR). The IRS publishes the AFR monthly, and the rate in effect when the loan originates governs the transaction.

Three tiers apply based on loan duration:

 

Loan Term	AFR Tier
3 years or less	Short-term AFR
3 to 9 years	Mid-term AFR
More than 9 years	Long-term AFR

 

If you charge less than the applicable rate, the IRS imputes interest income to you as the lender and treats the shortfall as an additional gift to your child. You will owe income tax on interest you never actually received.

Building a Legally Enforceable Promissory Note

A promissory note is the written record that separates a loan from a gift in the eyes of both the IRS and a court.

A compliant promissory note should include:

• The loan principal


• The interest rate, at or above the relevant AFR


• The repayment schedule, including due dates and payment amounts


• The consequences of default


• Whether the loan is secured or unsecured

If you secure the loan, you will also need a deed of trust or mortgage recorded against the property. Securing the note gives you a legal claim on the home if the borrower defaults, and it may allow your children to deduct the interest payments on their federal return.

Why Documentation Matters If Your Child Gets Divorced

A properly documented loan is a debt obligation. A gift is a marital asset. That distinction becomes critical if your child’s marriage ends.

When a down payment transfer is structured as a loan, a divorcing spouse generally cannot claim it as shared marital property, because it is money your child owes rather than money they own outright. An undocumented transfer, or one that a court reclassifies as a gift, is far more vulnerable to division.

Keeping the loan proceeds in a separate account before the home purchase closes adds another layer of protection and strengthens the separate-property argument.

Using a Third-Party Platform to Remove the Friction

One of the most practical decisions you can make is to route the loan through a third-party servicing platform. Services such as National Family Mortgage and Pigeon handle the administrative side of the arrangement:

• Generating IRS-compliant loan documents


• Processing and tracking monthly payments


• Issuing Form 1098 (mortgage interest) to the borrower and Form 1099-INT (interest income) to the lender


• Maintaining a payment ledger that documents the loan’s legitimacy

Beyond the paperwork, routing payments through a neutral platform removes the emotional friction of asking a family member for money every month, and it creates the payment history that supports the loan’s legal standing if it is ever challenged.

What Both Parties Need to Report at Tax Time

As the lender, you must report interest income on your federal return each year, whether you received actual cash payments or had interest imputed by the IRS.

Your child may be able to deduct mortgage interest if the loan is secured by the home and the lien is properly recorded.

Both parties should work with a tax professional in the first year the loan is active to establish correct reporting habits.

Note: If you die before the loan is repaid, the outstanding balance becomes an asset of your estate, so your estate planning documents should address how that balance will be handled among your heirs.

FAQs About Intra-Family Loans for Home Purchases

What Happens if I Already Gave My Child Money Informally Without a Loan Agreement?

If you transferred money without a formal loan structure, the IRS most likely treats it as a gift. If the amount exceeded the annual exclusion, you may have a late Form 709 filing obligation. Retroactively restructuring the transfer as a loan is possible in some situations but requires a tax attorney and is not guaranteed to hold up under audit. The most effective step you can take now is to establish proper documentation before any future transfers are made.

Does the Lender Have to Report Interest Income Even if the Rate Is Very Low?

Yes. If your rate equals or exceeds the AFR, you report the actual interest received as income. If your rate falls below the AFR, the IRS imputes interest to you based on the AFR, and you owe income tax on that amount even though no cash changed hands. Either way, the income is reportable. A CPA familiar with family loan rules should review your return in the first year the loan is active to make sure the reporting is handled correctly from the start.

Can My Child Deduct the Interest They Pay on a Family Loan?

In some cases, yes. If the loan is secured by the child’s primary residence and the lien is properly recorded with the county, the borrower may qualify for the mortgage interest deduction, subject to standard IRS rules. An unsecured promissory note generally does not qualify. This is one of the strongest practical reasons to formalize the loan with a recorded deed of trust or mortgage in addition to the promissory note, since it creates a tax benefit for the borrower while reinforcing the loan’s legal legitimacy.

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