Can the borrower deduct interest on a personal loan from family?

Usually, no. Interest on a family loan used for personal spending is personal interest, and the Internal Revenue Service (IRS) doesn't allow a deduction for it. The borrower can deduct the interest only when the loan fits another category, mainly a recorded mortgage on the borrower's home or money used for a business or investments.

Why isn't interest on a family loan usually deductible?

The IRS sorts interest by what the borrowed money pays for, and personal interest is the catch-all bucket. IRS Topic 505 says personal interest isn't deductible and lists examples such as "Credit card and installment interest incurred for personal expenses." A family loan used for a car, a wedding, a vacation, or paying down credit cards lands in that same bucket.

Who lent the money doesn't change the answer. The deduction depends on how the borrower uses the money and, for home loans, how the debt is secured. The one place the relationship does matter is student loans, covered below. A signed note doesn't change the answer either. Writing the loan down helps prove it's a real loan, but interest on money used for personal spending stays personal interest.

How does the IRS decide what kind of interest it is?

The IRS follows the money. Publication 550 says: "If you borrow money for business, personal purposes, or investment, you must allocate the debt among those purposes." It adds that "The allocation is not affected by the use of property that secures the debt."

Publication 550 walks through an example. You borrow $10,000, spend $8,000 on stock, and spend $2,000 on items for your home. Because 80 percent of the debt went to investment, 80 percent of the interest is investment interest, and the other 20 percent is nondeductible personal interest.

For a family loan, that means the borrower should keep the money traceable. Bank records showing where the loan proceeds went are the best evidence if the deduction is ever questioned.

When is interest on a family home loan deductible?

Interest on a loan from a relative can count as home mortgage interest, but only if the loan passes the same tests a bank mortgage does. IRS Publication 936 says you can't deduct home mortgage interest unless you file Form 1040 or 1040-SR and itemize deductions on Schedule A, and the mortgage is a secured debt on a qualified home in which you have an ownership interest. Both you and the lender must also intend that the loan be repaid.

"Secured debt" has a specific meaning. Publication 936 says the borrower signs an instrument, such as a mortgage or deed of trust, that makes the borrower's ownership in a qualified home security for the debt and provides that the home could satisfy the debt in case of default. The instrument also has to meet a third test: it "Is recorded or is otherwise perfected under any state or local law that applies."

That third test is the one a handshake family loan skips. A signed unsecured promissory note for a down payment is a valid loan, but its interest isn't deductible home mortgage interest, because the home isn't pledged and nothing is recorded. To make the interest deductible, the family lender needs a secured promissory note backed by a mortgage or deed of trust that's recorded under state law.

If the borrower bought the home from the same relative who's lending the money, Publication 936 says to show that person's name, address, and taxpayer identification number (TIN) on the dotted lines next to line 8b of Schedule A.

Can the borrower deduct interest if the loan pays for a business or investments?

Often, yes, because the interest follows the money. Topic 505 lists non-farm business interest among the kinds of interest you can deduct, with a note that it may be limited. This comes up when a parent lends money to an adult child's startup or a relative funds a family LLC.

Topic 505 also lists investment interest as an itemized deduction, limited to your net investment income. If the borrower uses a family loan to buy stocks or other investment property, that share of the interest can qualify, subject to that limit.

Here's a worked example. Your sister lends you $30,000 at 5 percent, and you put $24,000 into your business and spend $6,000 on a personal car. Under the allocation rule, 80 percent of the debt went to the business. A year of interest is $1,500, so $1,200 is business interest and $300 is nondeductible personal interest.

Either way, the paper trail carries the claim. Put the loan in writing, send the money straight to the business or brokerage account, and have payments come from that account.

Does a family student loan qualify for the student loan interest deduction?

Usually not. IRS Publication 970 says "You can't deduct interest on a loan you get from a related person." Related persons include your spouse, your brothers and sisters, your half brothers and half sisters, your ancestors (parents, grandparents, and so on), your lineal descendants (children, grandchildren, and so on), and certain corporations, partnerships, trusts, and exempt organizations.

So a loan from a parent or grandparent to pay tuition can't produce a student loan interest deduction, even if every other rule is met. The deduction also requires a loan taken out solely to pay qualified higher education expenses. When a loan does qualify, IRS Topic 456 says the deduction is an adjustment to income, so the borrower doesn't need to itemize.

What should the lender and borrower keep on file?

Put the amount, rate, repayment schedule, and purpose of the loan in a signed note. For a home loan, record the mortgage or deed of trust. For a business or investment loan, keep the bank statements that show where the money went. An installment promissory note with an amortization schedule also shows how much of each payment is interest.

The lender's side runs the other way. IRS Topic 403 says you must report all taxable interest on your federal return, even if you don't receive a Form 1099-INT. Interest the borrower can't deduct is still taxable income to the relative who receives it. Both sides should keep copies of the note and the payment history for as long as the loan is open.

Sources

• IRS Topic 505, Interest expense
• IRS Publication 936, Home Mortgage Interest Deduction
• IRS Publication 550, Investment Income and Expenses
• IRS Publication 970, Tax Benefits for Education
• IRS Topic 456, Student loan interest deduction
• IRS Topic 403, Interest received