Under rules set forth in the Internal Revenue Code, you can make loans to family members at rates lower than those charged by commercial lenders without it being deemed a gift.
Generally, if a parent gives an interest-free loan to a child, the IRS treats the foregone interest as a taxable gift. To prevent this, the parent must charge a minimum interest rate. To the extent that the interest charged on the loan is lower than the minimum, that amount will be imputed income to the parent, even though the parent does not actually collect it. The IRS will also treat that amount as a gift to the child, which would require the filing of a gift tax return.
However, if a parent establishes a creditor-debtor relationship with adequate stated interest, the intra-family loan will not be characterized as a transfer subject to the gift tax.
Intra-family loans create an opportunity to shift wealth from parent to child, if the child can earn a greater return on the amount borrowed than the AFR. To the extent that a child can earn a higher rate of return on the borrowed funds than the interest rate being paid, he or she is able to keep the excess without any gift taxes being paid.
Intra-family loans are also more beneficial than third party loans because they allow the total interest expense paid over the course of the loan to stay within the family rather than being paid to a bank.
Reference: Intra-family Loans: A Simple Yet Effective Estate Planning Tool, National Law Review, July 30, 2016.