Lending’s Memorandum of Understanding(MOU)

Before deciding to lend money, reflect on the strength and dynamics of your relationship. Is it robust enough to withstand potential financial disagreements? Remember, a healthy relationship is characterized by open communication, mutual respect, and understanding.

1.

DO THIS Write a memorandum of understanding (MOU), where each side agrees on their understanding of the loan terms and how it might play out. Clearly outline the loan’s terms, including the amount, interest rate (if any), repayment schedule, and any other conditions. The MOU is not binding; it is not a legal contract. The MOU can be as informal as you want. Nonetheless, have both sides sign and date the MOU.

(a)

Over time, both sides’ memory of what was agreed will fade — and they will fade in different directions. The signed MOU is the only record that holds.

(b)

If affairs devolve so that you need the MOU, it will be so (so (so)) much better that you have the MOU instead of not, in which case, there is an endless disagreement on what each side thought was the understanding. (And again, this will happen with decent odds.)

2.

Have the borrower, B, stipulate the repayment as much as possible. The most likely problem scenario is B’s inability to repay as intended and having had them write the terms is one fewer bone for them to pick.

3.

In writing the MOU, have a section on what happens if B cannot repay as intended. Cover both

(a)

delayed payment, and (ii) an outright reneging situation. Often both sides say “this cannot happen”, in which case I say, write something down and “it won’t matter as it cannot happen”, but at least write something down.

4.

Acknowledge the possibility that you might not get your loan repaid fully or on time. Think about how this could impact your finances and your relationship with the borrower. As the lender, it’s important to reflect on your feelings if the repayment doesn’t go as planned. You might not end up feeling exactly as you anticipate, but it’s good to have thought it through. If the risk to your relationship seems greater than the financial risk, it might be smarter to find other ways to help your loved one, like providing non-financial support or advice.

When you lend money at a rate below the Applicable Federal Rate (AFR), the IRS requires you to account for “imputed interest”. The AFR, which is updated monthly by the IRS to reflect market conditions, sets the minimum interest rate for private loans. For instance, in mid-2025 the short-term AFR (loans under 3 years) was 4.03%; the figure moves monthly with Treasury yields and has eased as Treasury rates fell through late 2025 and into 2026. If you provide a loan at a lower rate, such as 0.25% or zero interest, you are effectively making a financial gift equal to the uncharged interest.

Suppose you loan a friend $20,000 for one year at an interest rate of 0.1%. The actual interest paid by your friend would be $20 $(\$20,000\times 0.001=\$20)$. However, if the AFR at that time is 3%, the IRS expects you to have collected $600 $(\$20,000\times 0.03=\$600)$. The difference of $580 $(\$600-\$20)$ is the imputed interest — the amount the IRS treats as interest income you should have received. Whether you actually owe income tax on it depends on the exceptions below.

The $100,000 gift-loan exception does most of the work. Under IRC §7872(d), “Treatment of loans with below-market interest rates”, on a gift loan between individuals with an aggregate balance of $100,000 or less, the imputed interest the lender must report is capped at the borrower’s net investment income for the year — and if the borrower’s net investment income is $1,000 or less, the imputed interest is treated as zero. A child who borrows $20,000 to cover a down payment and holds no meaningful portfolio has no net investment income, so in the example above the lender reports nothing, not $580. The cap vanishes only if a principal purpose of the loan is tax avoidance. Above $100,000 the cap no longer applies and the full AFR-based imputation governs.

Certain loans are exempt from these rules entirely, particularly if they do not have a significant tax effect or are for amounts less than $10,000, provided the funds are not used for income-producing purposes (as outlined in IRS Publication 550).

Furthermore, if the interest shortfall (the imputed interest) falls below the annual gift tax exclusion limit, it can be treated as a gift without requiring extensive paperwork. For example, if you lend $100,000 at an imputed interest rate of 3%, resulting in $3,000 of imputed interest, this amount can be considered a gift within the exclusion limit. Lender can claim with no/minimal paperwork, that they gave Borrower a gift of $3K. With these numbers L can lend B $500K before gifting becomes an issue.

When making a loan between related parties, it is crucial to select the appropriate AFR based on the duration of the loan. The IRS categorizes loans into three types: short-term (three years or less), mid-term (more than three years but no more than nine years), and long-term (more than nine years). Using the correct AFR is essential because if the interest charged is below the AFR, the IRS may impute interest, adding it to the lender’s taxable income at the AFR rate rather than the actual interest received.

The annual gift tax exclusion remained at $19,000 per donor per recipient for 2025 and 2026 ($38,000 for a married couple split-gifting). If an interest shortfall (or any other loan- related transfer) exceeds the annual exclusion, the excess is a reportable gift on Form 709 and applies against the lifetime exemption.

What changes the planning calculus is the size of that lifetime pool. The OBBBA, signed July 4, 2025, permanently raised the unified gift and estate tax exemption to $15 million per individual ($30 million per married couple) beginning in 2026, indexed thereafter. For most families, intra-family loan shortfalls that exceed the annual exclusion are now a paperwork question, not a tax-cost question: file Form 709, apply against the $15M/$30M lifetime exemption, and move on. Aggressive uncharged interest or below-AFR structuring matters only when cumulative lifetime gifting begins to approach the exemption ceiling — a threshold most families will never reach.

It’s also worth noting that loans between individuals where the outstanding balance is below $10,000 are exempt from these rules, as the IRS considers the imputed interest on such small amounts to be de minimis, or too trivial to warrant consideration.

This framework helps prevent tax evasion tactics where large sums are disguised as loans rather than taxable gifts or compensation. Always consult the latest IRS guidelines or a tax professional when dealing with below-market-rate loans to ensure compliance and proper reporting.