Helping Your Mom Buy a House: The Tax Trap in a “Simple” Family Loan
How IRC §7872 can turn a 0% family loan into taxable income
Recently I came across a social media post where a physician wanted to help his mom buy a new home.
The plan sounded simple.
He would loan her $200,000 for the down payment so she could purchase the new house first. Then, once she sells her current home, she would pay him back.
Situations like this come up all the time.
When people think about how to structure a loan between family members, two ideas usually come up:
Make an interest-free family loan, or
Gift the money now and have mom give it back later
At first glance, both seem simple and financially reasonable.
But the tax consequences can be very different from what people expect.
Let’s walk through them.
Option 1: The 0% Family Loan
A loan with little or no stated interest is called a below-market loan if the rate is lower than the Applicable Federal Rate (AFR). The rules for these loans are found in Internal Revenue Code §7872.
For simplicity, let’s focus on the type most families actually use: a demand loan.
A demand loan means the lender can ask for repayment at any time. That fits our example. The son expects mom to repay him when her house sells, but there is no fixed maturity date.
Under IRC §7872, if a demand loan charges less than the AFR, the IRS pretends interest was charged anyway.
For tax purposes, the law treats the transaction as if the following happened each year:
The son makes a gift to mom equal to the foregone interest
Mom immediately pays that same amount back to him as interest
So the interest essentially bounces back and forth on paper.
Example
Assume the following:
Loan amount: $200,000
Stated interest rate: 0%
Short-term AFR: 5%
Loan outstanding for one full year
The imputed interest would be:
$200,000 × 5% = $10,000 of foregone interest
For tax purposes, the IRS treats the situation as if:
The son gave mom a $10,000 gift
Mom paid the son $10,000 of interest
Tax result
On the son’s side:
He must report $10,000 of interest income. If he is in the 37% bracket, that’s about $3,700 of federal tax.
At the same time, he is treated as having made a $10,000 gift.
Fortunately, the gift is below the 2026 annual gift exclusion of $19,000 per recipient, so no gift tax return is required.
If the deemed gift exceeded $19,000, the son would typically have to file Form 709, even though no tax would likely be due because of the large lifetime exemption.
Under current law, the lifetime estate and gift exemption is $15M per individual in 2026, and it will be indexed for inflation starting in 2027.
Now let’s look at mom’s side.
Mom is treated as having paid interest.
But personal interest is generally nondeductible under IRC §163(h) unless it qualifies for a specific exception.
One important exception is qualified residence interest under IRC §163(h)(3).
For that to work in a family-loan situation, the loan typically must:
Be properly documented
Be secured by the home (mortgage or deed of trust)
Be used to acquire the residence
Stay within the acquisition-debt limits ($750k for a single person)
If the loan is simply an informal IOU between family members, mom’s deemed interest usually is not deductible.
So the end result can be:
Taxable interest income to the son
No deduction for mom
Not exactly what most families had in mind.
As the saying goes, no good deed goes unpunished.
Option 2: “Gift It Now, Gift It Back Later”
Another idea people sometimes suggest is this:
The son gifts $200k to mom today
When she sells her house, she “gifts” $200k back to him
From a gift-tax standpoint, this may not create any actual tax liability because of the large lifetime exemption (i.e., $15M in 2026).
However, there are still consequences and risks.
First, the son’s $200,000 transfer exceeds the $19,000 annual gift exclusion amount.
That means $181,000 would be a taxable gift, which must be reported on Form 709, and it would use part of his lifetime exemption.
Second, if everyone expects from the beginning that mom will pay the money back when her house sells, the IRS may argue that $200k was never really a gift.
Labeling a transfer a “gift” does not automatically make it one if there is a clear expectation of repayment.
If the IRS recharacterizes the transaction as a loan, then the below-market loan rules under §7872 would apply anyway, just like in Option 1.
Which means the son could still end up recognizing imputed interest income.
Ouch. Ouch. Ouch.
Small Loan Rules Under IRC §7872
There are two small-loan rules in §7872 that sometimes help with family loans.
#1: Loans of $10,000 or less
If the total outstanding loans between the parties are $10,000 or less, the imputed interest rules generally do not apply.
However, this exception does not apply if the money is used to purchase income-producing assets (for example, mom buying a used Honda Accord to start a Turo business).
In our $200,000 example, this rule clearly does not help.
#2: Loans of $100,000 or less
If total loans between individuals do not exceed $100,000, the lender’s imputed interest income is limited to the borrower’s net investment income.
Net investment income includes things like:
Interest income
Dividends
Rental income
Other investment income
If the borrower’s net investment income (in this case, mom’s) is $1,000 or less, it is treated as zero for this rule.
So in that situation, no interest would be imputed to the lender (the son) for income-tax purposes.
However, this rule only limits the income tax impact.
It does not limit the deemed gift for gift-tax purposes.
In our $200,000 example, this rule also does not apply because the loan exceeds $100,000.
The Practical Structure Most Families Use
In real life, the cleanest solution is usually a properly documented family loan that charges at least the AFR.
That typically means:
A written promissory note
An interest rate at least equal to the AFR
A clear repayment term (for example, when mom’s house sells)
If interest deductibility for mom is important, the loan should also:
Be secured by the home with a recorded mortgage or deed of trust
Meet the requirements for qualified residence interest
Stay within the $750,000 acquisition-debt limit
A properly structured loan avoids the imputed-interest problem and matches the real economic intent of the family.
Final Thought
Helping family members financially, especially with housing, is common and often the right thing to do.
But once the dollar amounts get large, the tax rules can produce results that people don’t expect.
Under IRC §7872, a “simple” 0% family loan can quietly generate taxable interest income and deemed gifts each year.
Before moving large amounts of money within a family, it’s worth taking a moment to decide:
Is this really a gift?
Or is it really a loan?
And if it’s a loan, structuring it properly can prevent an unnecessary tax bill.
Sometimes a small change in documentation and interest rate can make a big difference.