The Applicable Federal Rate is the minimum interest rate the IRS requires on most private loans, published monthly to keep people from moving money tax-free by calling a gift a loan. For April 2026, the annual-compounding rates run from 3.59% on short-term loans (three years or less) to 3.82% mid-term (three to nine years) and 4.62% long-term (over nine years).1Internal Revenue Service. Rev. Rul. 2026-7 Charge less than the applicable rate and the IRS treats you as if you had collected the missing interest anyway. That phantom interest is taxable income to the lender, and in a family loan it usually counts as a gift to the borrower on top of that.
Why the Rate Exists
Two Code sections do the work. Section 1274 gives the IRS authority to set minimum rates on debt instruments.2Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property Section 7872 handles the consequences: on a below-market loan, the forgone interest is treated as if the lender had transferred it to the borrower (as a gift, compensation, or dividend depending on the relationship) and the borrower had immediately paid it back as interest.3Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates One handshake, two taxable events.
The rates themselves are anchored to what the federal government pays to borrow. The IRS averages the market yield on outstanding Treasury obligations over a one-month period and publishes the results as Revenue Rulings in the Internal Revenue Bulletin, usually just before the first of each month.4Internal Revenue Service. Applicable Federal Rates When Treasury yields rise, the AFR follows.
The Three Tiers
Every private loan falls into one of three buckets based on the repayment term:
- Short-term: three years or less.
- Mid-term: more than three but no more than nine years.
- Long-term: more than nine years.
Each tier is published at four compounding frequencies (annual, semiannual, quarterly, and monthly), so you can match whatever the note says. More frequent compounding produces the same effective yield at a slightly lower stated rate; the April 2026 quarterly figures are 3.54%, 3.76%, and 4.54%.1Internal Revenue Service. Rev. Rul. 2026-7 Picking the wrong tier is a real risk. If you write a seven-year note but use the short-term rate, the IRS can recharacterize the shortfall as imputed interest for the whole life of the loan.
Demand Loans Versus Term Loans
The tier isn’t the only variable. A term loan has a fixed maturity date; a demand loan doesn’t, because the lender can call it at any time. The two are treated differently.
On a term loan, the AFR is locked in on the day the loan is made and stays put for the life of the note. The tax consequence is front-loaded: the excess of the loan amount over the present value of all required payments is treated as transferred at origination.
On a demand loan, the short-term AFR always applies, and it resets as the short-term rate changes. Forgone interest is calculated at the end of each calendar year using whatever short-term rates were in effect that year.3Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates A vague “pay me back whenever you can” arrangement is a demand loan by default. You’ll owe income tax each year on interest you never received, and the same amount gets treated as a gift.
What Happens If You Charge Less Than the AFR
Family loans are where this comes up most often. When a parent lends to a child at zero interest, the forgone interest is a gift from lender to borrower, and the lender must also report it as interest income received. If total gifts to that person for the year (forgone interest included) exceed $19,000, the lender generally has to file Form 709, the federal gift tax return.5Internal Revenue Service. Frequently Asked Questions on Gift Taxes Filing 709 doesn’t necessarily mean owing gift tax; it draws down the lifetime gift and estate exclusion, which sits at $15,000,000 for 2026.6Internal Revenue Service. What’s New – Estate and Gift Tax
The borrower may be able to deduct the imputed interest if the loan qualifies, for example as home mortgage interest on an intra-family purchase loan. The lender’s duty to report the phantom income exists whether or not the borrower gets any deduction.
The $10,000 De Minimis Exception
Section 7872 lets small loans off the hook. If aggregate outstanding loans between two individuals stay at or below $10,000, imputed interest rules don’t apply.3Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates The exception disappears if the borrower uses the money to buy income-producing assets like stocks or rental property.
The $100,000 Investment-Income Cap
Between individuals, when aggregate loans stay at or below $100,000, the imputed interest the lender must report is capped at the borrower’s actual net investment income for the year. If the borrower’s net investment income is $1,000 or less, it’s treated as zero, which effectively eliminates the income tax hit. Cross the $100,000 threshold and the cap vanishes; the full AFR calculation applies.3Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates Neither safe harbor applies if a principal purpose of the arrangement is tax avoidance, and the IRS reads that broadly.
Where Else the AFR Matters
Below-market loan rules aren’t confined to families. When an employer lends to an employee below the AFR, the forgone interest is recharacterized as wages: taxable to the employee, deductible to the employer. When a closely held corporation lends to a shareholder below the AFR, the forgone interest can be recharacterized as a dividend. The $10,000 de minimis exception applies in these settings too, again subject to the tax-avoidance carve-out.3Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
Seller financing has its own version of the rule. When a seller carries a note instead of sending the buyer to a bank, the stated interest must meet or exceed the AFR in effect when the agreement becomes binding. If it doesn’t, Section 1274 recharacterizes part of the stated purchase price as interest, shrinking the amount treated as principal.7Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property For sales and exchanges, taxpayers can use the lowest AFR from the three-month window ending with the month the contract is signed, which helps when rates have jumped.
The AFR also feeds estate planning through the Section 7520 rate, used to value annuities, life estates, and remainder interests. The 7520 rate equals 120% of the mid-term AFR, rounded to the nearest two-tenths of a percent.8Office of the Law Revision Counsel. 26 USC 7520 – Valuation Tables Grantor Retained Annuity Trusts and charitable remainder trusts are built around it. A lower 7520 rate makes it easier for trust growth to pass to beneficiaries without gift tax.
How to Structure a Loan the IRS Will Respect
Courts have reclassified sloppy family loans as outright gifts more than once. The difference between a real loan and a disguised gift usually comes down to whether the paperwork exists and whether the parties actually behave like a lender and a borrower. To keep a private loan on the loan side of that line:
- Sign a written promissory note when the money changes hands, not months later. Include the amount, interest rate, payment schedule, and maturity date.
- Set interest at or above the AFR for the correct tier, and reference the specific Revenue Ruling. A five-year term loan made in April 2026 needs at least 3.82% at annual compounding.1Internal Revenue Service. Rev. Rul. 2026-7
- Give the loan a fixed repayment schedule. Vague timing looks like a gift.
- Actually make the payments, and use bank transfers so there’s a trail.
- If the borrower defaults, take some steps to collect. A lender who shrugs off missed payments looks like a donor.
Some families combine a loan with the annual gift exclusion, forgiving up to $19,000 of payments per year. That’s workable, but document each forgiveness separately so the underlying loan still looks enforceable.
Reporting and Penalties
Lenders report interest income (real or imputed) on Schedule B of Form 1040.9Internal Revenue Service. Instructions for Schedule B (Form 1040) Forgone interest that pushes total annual gifts to one person over $19,000 triggers a Form 709 filing.10Internal Revenue Service. Instructions for Form 709 Skipping that filing when required leaves the statute of limitations open on the gift indefinitely.
The usual penalty for underreporting is the 20% accuracy-related penalty under Section 6662, which applies when the understatement exceeds the greater of 10% of the tax due or $5,000.11Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments The larger risk isn’t the penalty. It’s reclassification. If the IRS decides a $500,000 interest-free “loan” was really a gift because nothing about it looked like a loan, the whole principal can become a taxable transfer. A signed note referencing the correct Revenue Ruling, documented payments, and honest reporting of the imputed interest are cheap compared to that outcome.