Loans to grandchildren are legal and increasingly common, but they carry a tax risk that loans from parents to children do not: the generation-skipping transfer tax. If you charge at least the IRS Applicable Federal Rate, put the terms in writing, and collect real payments, a loan to a grandchild is respected as debt, not a gift, and the generation-skipping tax almost never applies. The trap shows up when the loan is interest-free, undocumented, or quietly forgiven, because each of those moves can be reclassified as a gift to a "skip person," and skip-person gifts get taxed twice: once under gift tax rules and again under a separate 40% generation-skipping transfer tax if you run out of exemption.
This guide walks through why grandparent-to-grandchild loans get extra IRS scrutiny, what the generation-skipping transfer tax actually does, and how to structure the loan so it stays a loan.
This article covers U.S. federal tax rules only and is not tax or legal advice. Talk to a CPA or estate attorney before lending or forgiving a significant sum, especially if your estate is near the federal exemption threshold.
Why a Loan to a Grandchild Is Different From a Loan to Your Kid
A loan from you to your child moves down exactly one generation, which is what the tax code expects and taxes in the ordinary way. A loan from you to your grandchild skips your child's generation entirely. The IRS calls your grandchild a "skip person," and any gift-equivalent transfer to a skip person is potentially subject to the generation-skipping transfer tax (GSTT) on top of ordinary gift tax exposure.
Most family loan guides, including our guide to lending money to adult children, focus on the parent-child relationship because that is the far more common loan. Grandparent-to-grandchild loans need one extra layer of analysis: does any part of this transaction count as a taxable gift to a skip person, and if so, does it exceed the exemptions that shelter it.
The Generation-Skipping Transfer Tax, in Plain English
The GSTT exists so families cannot dodge a full generation of estate tax by handing assets straight to grandchildren instead of children. When it applies, the rate is a flat 40%, the same as the top federal estate tax rate, and it is charged in addition to any gift tax owed.
The good news: almost no family loan actually triggers it. Every taxpayer gets a GST exemption that, under the One Big Beautiful Bill Act signed in July 2025, matches the federal lifetime gift and estate tax exemption at $15 million per person for 2026 (irs.gov). Transfers that qualify for the annual gift tax exclusion, currently $19,000 per recipient in 2026, are generally excluded from GSTT too, as long as they meet the "present interest" requirement described below.
In practice, the GSTT only becomes a live issue when:
- You forgive a very large loan balance in one year, well past the annual exclusion, and you have already used up your $15 million lifetime exemption elsewhere.
- The loan is structured so badly (no interest, no repayment expectation, no paper trail) that the IRS recharacterizes the entire principal as a gift the day it was made.
- You die still holding the promissory note and the unpaid balance is large enough, combined with the rest of your estate, to matter at the $15 million exemption level.
For a typical $15,000 to $75,000 loan to help with a car, tuition, or a down payment, GSTT is not the primary risk. The gift-tax recharacterization risk described next is the one that actually catches families.
How the IRS Can Turn Your "Loan" Into a Taxable Gift
Under Internal Revenue Code Section 7872, a loan between family members must charge at least the Applicable Federal Rate for its term, or the IRS treats the difference between what you charged and what the AFR required as "imputed interest," a gift you made to the borrower each year the loan is outstanding. The IRS updates AFRs monthly and publishes them at irs.gov/applicable-federal-rates; the rate that applies for the life of a fixed-rate loan is whichever one was in effect the month you funded it.
For a loan to a grandchild, that imputed gift is a gift to a skip person. It still falls under your annual exclusion first ($19,000 per grandchild in 2026, $38,000 if you and your spouse split gifts), so small below-market loans rarely cause a problem. But two things make grandparent loans riskier than parent-child loans:
- No genuine expectation of repayment. If there is no promissory note, no interest rate, and no evidence you ever asked for a payment, the IRS can recharacterize the entire original principal as a gift on the date you handed it over, not just the foregone interest. At that size, you can blow past the annual exclusion in a single transaction.
- Family loans to skip persons get more audit attention. Because the IRS specifically watches for GSTT avoidance, a large interest-free "loan" to a grandchild that is never repaid looks, on paper, exactly like an attempt to move wealth two generations without paying estate or gift tax on the middle generation.
The fix is the same one that protects parent-child loans: a signed promissory note or full loan agreement, an interest rate at or above the AFR for the loan's term, a fixed repayment schedule, and evidence you actually enforce it.
Forgiving the Loan Later Isn't a Free Pass
Many grandparents structure the transfer as a loan on paper, intending to forgive part or all of it down the road. That is legal, but each year's forgiveness is treated as a new gift in that year, valued at whatever principal and accrued interest you cancel.
To stay clear of both gift tax and GSTT:
- Keep any single year's forgiveness at or below your $19,000 annual exclusion per grandchild (or $38,000 for a married couple splitting gifts).
- Forgive in writing, dated, and keep records, an undocumented "I told them not to worry about it" does not hold up if the IRS ever asks.
- If you plan to forgive more than the annual exclusion in one year, you will need to file IRS Form 709 and apply the excess against your lifetime exemption. That is not a disaster at $15 million of exemption, but it does start the paperwork trail the IRS expects to see.
Loan vs. Outright Gift vs. Forgiven Loan: Tax Treatment Compared
| Structure | Annual exclusion applies? | GSTT exposure | Best for |
|---|---|---|---|
| Documented loan, AFR interest, real repayment | Not a gift at all | None, it is debt | Amounts you want repaid; down payments, tuition, business capital |
| Outright cash gift | Yes, up to $19,000/recipient in 2026 | Only if it exceeds exemption | Smaller, one-time help you never expect back |
| Loan later forgiven year by year | Yes, each year's forgiven amount counts separately | Low, if forgiveness stays within annual exclusion | Grandparents who want flexibility to change their mind |
| Interest-free loan with no paper trail | No, IRS may treat full principal as a gift | Higher, full amount can hit exemption at once | Not recommended |
A Real Scenario: $60,000 Toward a First Home
Say a grandmother lends her granddaughter $60,000 toward a home down payment in 2026, structured as a 10-year loan. The long-term AFR for that month (published monthly at irs.gov/applicable-federal-rates) sets the minimum rate she must charge to avoid imputed interest. If she charges that rate or higher, documents it with a signed note, and her granddaughter makes the scheduled payments, this is a loan, full stop. No gift tax return, no GSTT, no exemption used.
If the grandmother instead charges 0% and never collects a payment, the IRS can treat the $60,000 as a gift the year it was made. That exceeds her $19,000 annual exclusion by $41,000, which she must report on Form 709 and which draws down $41,000 of her $15 million lifetime exemption. It will not create a tax bill at that level, but it does eliminate the "just a loan between family" defense if anyone (an ex-spouse in a later divorce, a sibling contesting an estate, or the IRS) ever challenges the transfer.
How to Structure a Grandparent-to-Grandchild Loan Correctly
- Put it in writing. A signed promissory note or full loan agreement naming principal, interest rate, term, and repayment schedule is the single biggest factor in whether the IRS respects the loan as a loan.
- Charge at least the AFR for the loan's term (short-term for up to 3 years, mid-term for 3 to 9 years, long-term for over 9 years), locked in for the month you fund the loan.
- Track every payment. A spreadsheet that never gets updated is not evidence of a real loan; a running ledger of dates and amounts is. Family Loan Tracker logs payments, calculates amortization, and generates the agreement so you have a paper trail if it is ever questioned.
- Decide your forgiveness plan before you lend, not after. If you intend to eventually forgive the balance, cap each year's forgiveness at the annual exclusion and document it.
- Plan for what happens if you die first. An outstanding note becomes part of your estate; see our guide on what happens to a family loan when the lender dies for how executors typically handle it.
- Loop in a professional above roughly $250,000 or whenever the loan is large enough, relative to your total estate, that GSTT or lifetime exemption use becomes a realistic concern.
When to Call a Professional
If your estate is anywhere near the $15 million federal exemption, if you are lending through a trust, or if you are forgiving large amounts on a schedule, a CPA or estate attorney should review the structure before you sign anything. GSTT calculations involve exemption allocation elections that are easy to get wrong and expensive to unwind. For everyone else lending a more typical sum for tuition, a car, or a down payment, a properly documented loan at or above the AFR keeps you well clear of both gift tax and GSTT.
Ready to put a grandchild loan on paper? Create a free loan agreement with the right interest rate and repayment schedule built in, or see our complete guide to family loans and taxes for how the IRS treats family lending more broadly.
