When you sell a valuable item like a house, stock, or even a car and earn a profit, that gain may be subject to taxation. Not all profits are taxed the same way. Some are considered short-term and taxed like regular income, while others are treated as long-term and taxed at more favorable rates. The length of time you owned the asset plays a major role in how much tax you’ll owe.
Capital gains tax is a key consideration when making decisions about selling investments or assets. Understanding the distinction between short-term and long-term gains, the applicable rates, and when taxes apply can help you minimize what you owe and keep more of your profits.
What Is a Capital Gain?
A capital gain occurs when you sell a capital asset for more than you paid for it. Capital assets include most personal or investment property such as real estate, stocks, bonds, mutual funds, vehicles, and collectibles. The amount you paid when you acquired the item is known as your cost basis. The difference between the sale price and the cost basis is your capital gain.
If the sale price is less than your cost basis, you incur a capital loss. You are not taxed on losses, but you can use them to offset gains and, in some cases, even reduce your taxable income.
Short-Term vs. Long-Term Capital Gains
Capital gains are categorized based on the length of time you held the asset before selling it. This categorization determines how the gain is taxed.
Short-term capital gains apply to assets sold within one year of acquisition. These are taxed as ordinary income, using the same rates that apply to wages and other compensation.
Long-term capital gains apply to assets held for more than one year before being sold. These gains are taxed at reduced rates, often resulting in substantial savings compared to short-term tax rates.
For example, if you sell stock that you held for eleven months, the gain is short-term and could be taxed at rates as high as 37 percent. If you waited just one more month to sell, the gain would qualify for long-term treatment and be taxed at a maximum of 20 percent, depending on your income level.
Conditions for Long-Term Capital Gains
To benefit from long-term capital gains tax rates, you must meet a holding period requirement. You must hold the asset for more than one year—365 days is not enough. The IRS requires that the asset be held for one year and one day to qualify for long-term treatment.
The start date for the holding period begins the day after you purchase the asset and includes the day you sell it. If you acquired the asset on May 1, 2022, you would need to wait until at least May 2, 2023, to sell it and receive long-term tax treatment.
This rule applies to all capital assets, including investment securities, personal items, and real estate. Failing to meet the holding period can result in higher taxes.
Understanding the Cost Basis
The cost basis is the original value of an asset for tax purposes. It generally includes the purchase price, plus any related costs such as commissions or fees. If you made improvements to the asset (such as renovations to a home), those costs may also increase your basis.
When you sell the asset, the capital gain is calculated by subtracting the adjusted basis from the net proceeds of the sale. Proper documentation of your cost basis is crucial to accurately calculating the gain and avoiding overpaying taxes.
Long-Term Capital Gains Tax Rates for 2024
Long-term capital gains are taxed based on your taxable income and filing status. The tax rates for 2024 range from 0 to 20 percent. Below is the breakdown for each filing status:
Single Filers
- 0 percent for taxable income up to $47,025
- 15 percent for income between $47,026 and $518,900
- 20 percent for income above $518,900
Married Filing Jointly
- 0 percent for taxable income up to $94,050
- 15 percent for income between $94,051 and $583,750
- 20 percent for income above $583,750
Married Filing Separately
- 0 percent for income up to $47,025
- 15 percent for income between $47,026 and $291,850
- 20 percent for income above $291,850
Head of Household
- 0 percent for income up to $63,000
- 15 percent for income between $63,001 and $551,350
- 20 percent for income above $551,350
Your total taxable income determines which portion of your capital gains are taxed at each rate. It is possible for different portions of the same gain to fall into different brackets.
Example of a Long-Term Capital Gain Calculation
Suppose you bought shares of a company for $10,000 on March 1, 2010. On May 1, 2023, you sold the shares for $20,000. The result is a capital gain of $10,000. Since you held the asset for more than one year, it qualifies as a long-term gain.
If your total taxable income in 2024 is $65,000 and you are filing as a single taxpayer, your gain falls within the 15 percent bracket. Your capital gains tax would be $1,500. This tax is separate from the income tax you pay on your wages or other sources of income.
What About Assets Sold at a Loss?
When you sell a capital asset for less than your cost basis, you incur a capital loss. Capital losses are not taxed. Instead, they can be used to reduce your overall tax liability in several ways. First, losses offset gains of the same type. Long-term losses reduce long-term gains, and short-term losses reduce short-term gains. If losses exceed gains, the remaining loss can offset the opposite type of gain.
If your total capital losses for the year exceed your capital gains, you can use up to $3,000 of the remaining losses to reduce your ordinary income. If your losses still exceed that amount, the excess can be carried forward to future tax years. Strategic loss harvesting can help investors reduce tax liabilities in high-income years or when realizing large capital gains.
Special Capital Gains Tax Rules
Certain assets are subject to different long-term capital gains tax rules. For instance, collectibles such as art, antiques, or rare coins can be taxed at a maximum rate of 28 percent, regardless of your income level.
Depreciable real estate used in a business is another example. Gains attributable to depreciation deductions are taxed at a maximum rate of 25 percent. This is known as unrecaptured Section 1250 gain. If you claim depreciation on a rental property and later sell it for a gain, part of that gain may be subject to the higher 25 percent rate. These exceptions highlight the importance of understanding the nature of the asset and any tax-specific rules that may apply.
How the Net Investment Income Tax Affects Capital Gains
In addition to the regular long-term capital gains tax, high-income taxpayers may owe an additional 3.8 percent tax on net investment income. This applies if your modified adjusted gross income exceeds certain thresholds:
- $200,000 for single filers
- $250,000 for married filing jointly
- $125,000 for married filing separately
Net investment income includes interest, dividends, capital gains, rental income, and royalty income. This tax is added on top of the regular capital gains tax, raising the total rate for affected individuals.
To reduce the impact of the net investment income tax, certain deductions may be applied. These include investment interest expenses, state and local taxes related to investment income, brokerage fees, and rental property expenses.
Selling Your Primary Residence
A major exception to long-term capital gains tax applies when selling your primary residence. If you have lived in the home for at least two out of the last five years before the sale, you may exclude up to $250,000 in gain from your income ($500,000 if married filing jointly).
This exclusion is only available for primary residences, not rental or investment properties. It can only be used once every two years, and you must meet both ownership and use tests. This provision provides significant tax relief for homeowners who experience appreciation in property value over time.
Importance of Accurate Record-Keeping
Proper documentation is essential when it comes to calculating capital gains. Records should include:
- Original purchase price of the asset
- Fees and commissions paid at purchase and sale
- Costs of improvements (for real estate)
- Records of depreciation claimed (for rental properties)
- Any documentation supporting the holding period
Without these records, calculating the correct cost basis becomes difficult, and you could end up paying more tax than necessary. Good record-keeping also helps support your position if your return is ever audited.
Understanding Applicable Federal Rates (AFRs)
The IRS publishes Applicable Federal Rates (AFRs) every month, which are the minimum interest rates that should be applied to loans, including family loans, to avoid tax complications. These rates vary depending on the term length of the loan and the compounding method. There are three main categories:
- Short-term AFR: For loans up to 3 years
- Mid-term AFR: For loans between 3 and 9 years
- Long-term AFR: For loans longer than 9 years
AFRs are a crucial part of structuring family loans to ensure compliance with federal tax rules. If a family member lends money and does not charge at least the minimum AFR, the IRS may treat the loan as a gift, which could trigger gift tax consequences.
Avoiding Below-Market Loan Pitfalls
A below-market loan occurs when the interest rate charged on a loan is less than the applicable AFR. In such cases, the IRS may impute interest on the loan, meaning it may treat the lender as though they received the AFR interest even if no interest was paid. The imputed interest is then subject to income tax, and the difference between the interest charged and the AFR may be considered a gift.
This can create two tax concerns:
- The lender may owe tax on interest income they never actually received.
- The lender may have made an unintended taxable gift to the borrower.
Properly documenting the loan and charging at least the AFR can help avoid these complications.
Gift Loans and De Minimis Exceptions
The IRS provides a special rule for small loans made between family members. If the total outstanding loans between the lender and borrower do not exceed $10,000, and the loan is not used to purchase income-producing assets (like a rental property or stocks), then the imputed interest rules generally do not apply. This is often referred to as the de minimis exception.
For loans under $100,000, if the borrower’s net investment income is less than $1,000, the imputed interest may also be limited. This rule helps reduce the burden of tracking interest for small or informal family loans, particularly those used for personal expenses like medical bills, education, or wedding costs.
Importance of a Written Loan Agreement
Even though family loans often begin informally, a written loan agreement is essential for several reasons. It provides legal clarity, ensures the loan is recognized for tax purposes, and outlines key terms that prevent misunderstandings. A written agreement should include:
- Names of both lender and borrower
- The loan amount
- Interest rate
- Repayment schedule
- Collateral, if applicable
- Consequences of missed payments
Having a written contract helps the IRS view the arrangement as a legitimate loan rather than a disguised gift. It can also provide legal protection in case of disputes.
Creating a Promissory Note
A promissory note is a formal written promise to repay a loan under agreed-upon terms. While not legally required for small loans, creating a promissory note is highly recommended. It acts as a legally enforceable document and strengthens the legitimacy of the loan.
The promissory note should outline the same terms listed in the loan agreement and may be notarized or signed in the presence of a witness to reinforce its authenticity.
Including a Payment Schedule
Establishing a repayment schedule is important both for legal reasons and to set expectations between the lender and borrower. A repayment schedule may be monthly, quarterly, or annually, and should detail the payment amounts, dates, and methods (e.g., bank transfer, check, or direct deposit).
Adhering to a payment schedule can demonstrate the legitimacy of the loan to the IRS and help both parties manage their finances. A repayment schedule can be set up manually or through spreadsheet templates that track principal and interest payments over time.
Recording and Reporting Interest Income
Even though family loans are made informally, interest income received by the lender must be reported on their tax return. The borrower typically does not report the interest paid unless the loan is for business or investment purposes.
For the lender, interest income should be included in their gross income on Form 1040. If the interest is significant, it may also be reported on Schedule B. Failing to report interest can lead to IRS scrutiny and penalties, even if the loan was between close relatives.
If the loan generates more than $10 of interest income, the borrower may be required to issue Form 1099-INT to the lender, depending on how the funds are used and the relationship between the parties.
Tax Implications for the Borrower
The borrower usually does not get to deduct interest paid on a personal loan. However, there are exceptions. If the loan proceeds are used for qualified education expenses, the interest may qualify for the student loan interest deduction. Similarly, if the loan is used to buy or improve a home and is secured by the home, it may qualify for the mortgage interest deduction.
If the borrower defaults on the loan, the lender may report a non-business bad debt, which can sometimes be written off as a short-term capital loss. This requires documentation showing reasonable attempts to collect the loan.
Gift Tax Considerations
When a family loan is structured without interest or with below-market interest, part of the loan may be treated as a gift. The IRS allows an annual gift tax exclusion ($18,000 per recipient in 2024). If the imputed interest or unpaid loan amount exceeds this threshold, the lender may need to file Form 709 (Gift Tax Return).
Over a lifetime, individuals have a lifetime gift and estate tax exemption ($13.61 million in 2024), but gifts over the annual exclusion reduce this exemption. Careful planning is needed to avoid unexpected gift tax liabilities when making large family loans.
Refinancing or Forgiving a Family Loan
Sometimes the terms of a family loan need to be revised due to changing circumstances. The borrower might struggle with payments, or the lender may choose to forgive part of the debt. If any portion of the loan is forgiven, it may be considered a taxable gift.
Loan forgiveness must be carefully documented. If the loan is refinanced, a new agreement should be signed, and the old one should be marked as void or amended. If interest is reduced or eliminated, the new arrangement must still comply with IRS guidelines to avoid gift tax exposure.
Structuring Loans for Large Amounts
For loans above $100,000, it is especially important to observe all IRS guidelines. This includes charging at least the AFR, reporting interest income, and filing any necessary forms. Lenders of large family loans should consider consulting with a tax professional or financial advisor to ensure that the loan complies with IRS expectations.
Collateral may also be required in high-value loans to protect the lender’s interests. In such cases, a lien or security interest may be filed with the appropriate state agency. This converts the loan into a secured debt, providing a legal right to repossess the collateral in case of non-payment.
Legal Enforcement and Collection Challenges
Enforcing repayment of a family loan can be emotionally and legally complex. If the borrower fails to repay and there’s no written agreement, courts may view the transaction as a gift rather than a loan. This limits the lender’s ability to pursue legal action.
With a signed loan agreement or promissory note, the lender may pursue civil remedies such as small claims court or debt collection. However, going to court can strain family relationships, so many lenders prefer mediation or settlement. Preventing disputes through clear documentation and communication from the beginning is far preferable to dealing with collections later.
Using Family Loans for Business Purposes
Some family members provide loans to help others start or expand a business. In such cases, the IRS treats the transaction more like a traditional commercial loan. Interest payments are generally tax-deductible by the borrower as a business expense, and the lender must report interest income as usual.
If the borrower’s business fails and the loan is not repaid, the lender may be able to claim a non-business bad debt loss. This typically qualifies as a short-term capital loss, but requires demonstrating that the loan was made with an expectation of repayment, not as a gift. Business-related loans should always include robust documentation, including the business plan, loan purpose, and payment forecasts.
Intergenerational Loans and Estate Planning
Family loans can be used as part of an estate planning strategy. For example, a parent may loan a large sum to a child at the current AFR, and the child may use those funds to invest in appreciating assets. Over time, the appreciation may escape estate tax because it occurs in the child’s estate, not the parent’s.
Intra-family loans also allow asset transfers without using the lifetime gift tax exemption, as long as they follow IRS rules. Some families use grantor retained annuity trusts (GRATs) or intentionally defective grantor trusts (IDGTs) in conjunction with intra-family loans for sophisticated estate planning. Such strategies should be structured with guidance from tax attorneys or estate planners, as they involve complex rules and documentation.
Interest-Only Loans vs. Amortized Loans
Family loans may be structured in several ways. Two common types are:
- Interest-only loans: The borrower pays only interest during the loan term, with a balloon payment of the principal at the end.
- Amortized loans: The borrower pays both principal and interest in regular installments until the loan is fully repaid.
Each method has its pros and cons. Interest-only loans allow lower monthly payments, which can be beneficial for borrowers who expect future income growth. Amortized loans reduce the principal over time and may be viewed more favorably by the IRS. Both should be structured carefully, with clear repayment terms and a schedule that reflects the agreed structure.
Understanding IRS Treatment of Forgiven or Defaulted Family Loans
Family loans can strengthen relationships when handled wisely, but poor planning can lead to tax troubles. When loans are forgiven or go unpaid, the IRS may treat them as gifts or even taxable income. We focus on the implications of forgiving or defaulting on family loans, emphasizing the importance of documentation, gift tax thresholds, and the consequences of audit scrutiny.
The IRS View on Forgiven Family Loans
When a lender chooses to forgive a family loan, it often shifts from a loan to a gift in the eyes of the IRS. A loan is expected to be repaid, so if repayment is waived, the nature of the transaction fundamentally changes.
To determine whether forgiveness constitutes a gift, the IRS reviews intent, documentation, and past repayment history. If the arrangement lacks proper terms or there was never a realistic expectation of repayment, the IRS may argue the loan was a gift from the start.
Forgiveness can trigger the requirement to file a gift tax return if the amount forgiven exceeds the annual gift tax exclusion. In 2025, this exclusion stands at $18,000 per recipient. If a parent loans a child $60,000 and later forgives it, $42,000 exceeds the exclusion and must be reported using Form 709.
Annual Gift Tax Exclusion and Unified Credit
If the forgiven portion of the loan exceeds the exclusion limit, the donor must report it to the IRS. While most individuals won’t owe tax immediately because of the lifetime gift and estate tax exemption (around $13.61 million in 2025), reporting is still required.
Form 709, the United States Gift (and Generation-Skipping Transfer) Tax Return, is due on April 15 following the year of the gift. This form tracks cumulative gifts and applies them to the donor’s lifetime limit. Failing to file Form 709 can lead to penalties and IRS scrutiny.
Defaulted Loans and Imputed Gifts
Sometimes the borrower fails to repay the loan despite the lender not explicitly forgiving it. When there is no legal enforcement or repayment activity, the IRS may consider the loan effectively forgiven, and thus a gift.
In cases where the borrower ceases payments and the lender does not pursue collection, the IRS could infer that the lender intended to forgive the loan. Even without a formal statement, this inaction can result in imputed gifts.
The IRS may backdate this gift to the time of non-repayment, causing complications in determining applicable gift tax exclusions for the relevant year. This again underscores the importance of actively managing and documenting loan enforcement efforts, even among family.
Debt Cancellations and Potential Income to Borrower
There’s another angle to be aware of. Under certain conditions, especially when a family member acts more like a business lender, a cancelled loan may be considered taxable income for the borrower.
While this is rare in family settings, it’s possible if the loan was used in a business context or provided to a family member with whom the lender has a joint business interest. In such cases, cancelled debt may fall under the IRS’s cancellation of debt (COD) income rules. The borrower would then be required to report the cancelled debt on Form 1040, possibly triggering tax obligations depending on insolvency or bankruptcy exceptions.
Statute of Limitations and Implications for Family Loans
If a lender has not attempted to collect the loan after a certain number of years, depending on state law, the debt may be considered legally unenforceable. This time period is governed by the statute of limitations for contract enforcement in each state.
Once a loan falls outside the enforceable timeframe, the IRS may assert that the lender had no intent to collect it—essentially making it a gift. As this occurs by operation of law, not by conscious choice, families must be aware of legal timelines and renew loan agreements where needed to preserve the loan’s enforceability.
IRS Audit Triggers for Forgiven or Stale Loans
Loans forgiven or allowed to lapse without collection can invite audits under certain conditions. Common red flags include:
- Loans with no payment activity for multiple years
- No formal documentation or repayment schedule
- Loans that resemble gifts in size or structure
- Patterns of repeated loan forgiveness
- Loan arrangements between taxpayers under audit for unrelated issues
During an audit, the IRS may recharacterize large family loans as gifts if they believe the structure lacks economic substance. Interest-free or under-documented loans are especially vulnerable. This can lead to unexpected tax liabilities, penalties, and interest charges.
Writing Off a Family Loan as a Bad Debt
If a family member fails to repay a loan, lenders may hope to deduct the loss as a nonbusiness bad debt. However, the IRS allows this deduction only under narrow circumstances.
To deduct a bad debt, the lender must prove:
- The loan was bona fide with a clear expectation of repayment
- The lender took reasonable steps to collect it
- The loan has become wholly uncollectible
Nonbusiness bad debts are deductible only as short-term capital losses. If the loan is repaid in part, only the unrecovered balance can be claimed. Documentation is essential. Form 8949 and Schedule D must be filed with the tax return, along with any supporting evidence. Note that if the IRS views the loan as a gift from the beginning, the deduction will be denied outright.
Role of Written Promissory Notes in IRS Disputes
One of the strongest defenses against IRS recharacterization is a written promissory note signed by both parties. This legal document outlines repayment terms, interest, and default remedies. It demonstrates that both parties intended to enter into a valid debtor-creditor relationship.
A note should specify:
- Loan principal and interest rate
- Repayment schedule (monthly, quarterly, annually)
- Start and end dates
- Collateral or security (if applicable)
- Provisions for default or early repayment
Even if informal in style, having the agreement in writing and signed protects both parties during IRS examinations or legal disputes.
Interest Forgiveness and Compound Gift Risk
Forgiving accrued interest on a family loan may seem harmless, but the IRS views this as a separate gift. This applies to loans above the threshold where imputed interest rules apply.
For example, if the lender waives $1,200 in annual interest, that’s a gift. If this continues for several years, each instance counts as a separate gift, potentially pushing the total beyond the exclusion limit and requiring a gift tax filing. To avoid this, interest should be charged and paid on time. If interest is waived, it must be tracked and reported properly under gift tax rules.
Multiple-Year Forgiveness Strategy
Some families use a multi-year forgiveness approach to avoid exceeding the gift exclusion in one year. A parent may forgive $18,000 of the loan balance each year, gradually eliminating the debt without triggering a taxable gift.
This strategy requires:
- Clear annual documentation stating the forgiven amount
- Consistency with IRS filing requirements
- Adjusting the remaining balance after each forgiveness event
This approach is valid but must be carefully executed to avoid IRS scrutiny. Forgiveness should not be pre-agreed in the original loan terms, or it risks being treated as a disguised gift from the beginning.
Forgiveness Through Estate Planning
Another alternative is for the lender to maintain the loan as an asset until their death, then forgive it through estate planning. If the loan remains outstanding at death, it can either be:
- Included in the estate, requiring repayment by the heir
- Forgiven through the will, reducing the heir’s inheritance accordingly
Forgiveness through the estate can have favorable tax consequences, especially when the total estate is under the federal exemption amount. However, estate planners must ensure the loan is listed as an asset and accounted for in the estate valuation.
Role of Third-Party Services and Legal Help
Family loan forgiveness and defaults often blur the line between tax-free assistance and taxable gifts. To manage this risk, many families engage tax advisors or estate planning attorneys.
Services they may assist with include:
- Drafting legally sound promissory notes
- Preparing Form 709 for gift tax filings
- Structuring multi-year forgiveness plans
- Clarifying the loan’s treatment in estate documents
- Advising on enforcement options for defaulted loans
Having a professional guide can prevent common mistakes like failing to impute interest or misclassifying the forgiven amount. It also builds a strong defense in case of an audit or family dispute.
IRS Documentation Expectations
In the event of an audit, the IRS will examine the paper trail to decide if the loan was genuine. Important documents include:
- Signed promissory notes
- Bank transfer records or canceled checks
- Payment receipts or loan amortization schedules
- Written forgiveness declarations (if any)
- Gift tax filings (Form 709)
Lack of any of these elements may undermine the legitimacy of the loan. Taxpayers are strongly encouraged to keep records for at least seven years, and preferably longer if the loan term extends beyond that.
When Legal Enforcement Is Necessary
To preserve the loan’s legitimacy, the lender should take reasonable enforcement actions if repayment stops. This might include:
- Sending reminder notices or formal demand letters
- Restructuring the loan with modified terms
- Consulting legal counsel for collection options
Though lawsuits between family members are undesirable, pursuing collection action (or at least documenting an effort to do so) can help maintain the loan’s standing as a true debt.
Conclusion
Navigating IRS family loan guidelines can be complex, but with a solid understanding of the key principles, families can structure loans that are both financially sound and legally compliant. At the heart of the IRS rules is the need for transparency and formality, even when dealing with close relatives. Documenting loans properly, charging at least the Applicable Federal Rate (AFR), and issuing a written promissory note are not just best practices but vital steps to avoid tax complications and unintended gift tax consequences.
When family loans are treated casually, the IRS may view the transaction as a gift, potentially triggering unwanted tax liabilities. Properly structured family loans, on the other hand, can help relatives buy homes, fund businesses, or cover education costs in ways that are more flexible and affordable than traditional lenders. However, this flexibility doesn’t eliminate the need for adherence to IRS standards, especially when loans exceed the annual gift tax exclusion threshold or when the borrowed funds generate income-producing assets.
Moreover, repayment plans, interest tracking, and tax reporting responsibilities should not be overlooked. Both the lender and borrower must report interest income and deductions correctly, and they should keep thorough records to support their tax positions. Missteps in any of these areas can lead to audits, penalties, or strained family relationships.
Ultimately, when handled correctly, family loans offer a powerful way to transfer wealth, provide support, and strengthen financial security across generations. But the importance of combining good intentions with clear documentation and compliance cannot be overstated. Whether lending or borrowing, families are best served by treating these transactions with the same seriousness as any formal financial agreement backed by the appropriate paperwork and aligned with IRS expectations.