Below-Market Loans: AFR, Imputed Interest, and Safe Harbors

A below-market loan is any loan that charges interest below the applicable federal rate the IRS publishes each month, and the tax code treats the missing interest as a taxable transfer between the parties. Under 26 U.S.C. § 7872, that gap can create income tax for the lender and, in family situations, gift tax as well.¹ For May 2026, the annual-compounding AFRs are 3.82% short-term, 4.08% mid-term, and 4.83% long-term.² Charge less than the rate that matches your loan’s term, and the IRS fills in the difference on paper whether or not any cash ever moves.

Which Loans Are Covered

Section 7872 does not sweep in every informal loan. It targets four relationships where a low interest rate is most likely to hide something else:

Gift loans between individuals, typically family members, where the low rate reflects generosity. A parent lending a child $200,000 at zero interest is the classic case.
Compensation-related loans between an employer and employee, or between a service recipient and an independent contractor.
Corporation-shareholder loans, which the IRS watches because they can function as disguised dividends.
Tax avoidance loans, a catch-all covering any arrangement where a principal purpose of the interest structure is reducing federal tax.

The category matters because it dictates how the imputed transfer is characterized. A gift loan produces a deemed gift; a compensation loan produces deemed wages; a corporation-shareholder loan produces a deemed dividend. Reporting a shareholder loan as a gift, or vice versa, puts the transaction on the wrong lines of the return.¹

The Applicable Federal Rate

The AFR is the IRS’s monthly benchmark for whether a loan charges enough interest. Treasury publishes a revenue ruling each month, and the rate that applies to your loan locks in based on when the loan is made and how long it runs. Section 1274(d) sets three tiers:³

Short-term: three years or less.
Mid-term: more than three years, up to nine.
Long-term: more than nine years.

Pull the rate for the month the loan actually originates, not the month you get around to signing paperwork. Each ruling also lists rates for annual, semiannual, quarterly, and monthly compounding; the version you charge has to match the compounding period stated in the loan agreement. For demand loans, the AFR is retested every year, so you need to look up the current short-term rate annually.⁴

How Imputed Interest Works

When a loan charges less than the AFR, Section 7872 treats the shortfall as two simultaneous transactions. First, the lender is deemed to transfer the missing interest to the borrower as a gift, wages, or dividend depending on the relationship. Then the borrower is deemed to hand that same amount right back to the lender as interest.¹

The result trips people up because no cash moves for the imputed portion, yet the tax is real. The lender reports interest income they never actually received. The borrower may report a gift or additional wages they never actually got.

Demand Loans vs. Term Loans

Timing depends on the loan structure. A demand loan is one the lender can call at any time, including any loan with no stated maturity. For those, the IRS calculates forgone interest each calendar year and treats it as transferred on December 31, so you report it every year the loan stays open.

A term loan has a fixed repayment date, and the entire imputed amount is recognized upfront on the day the loan is made. The IRS discounts all required payments back to present value using the AFR, and the difference between that present value and the principal is the deemed transfer. On a large, long-term, zero-interest loan, that front-loaded number is significant.¹

Gift Tax on Family Loans

For gift loans, the imputed interest is not just an income tax issue for the lender. It is also a deemed gift to the borrower, and it counts against the lender’s annual gift tax exclusion. For 2026 that exclusion is $19,000 per recipient.⁵

If the annual imputed interest stays under $19,000, the exclusion absorbs it. Above that, the lender either owes gift tax or eats into the $15 million lifetime exemption. The math turns quickly on large balances: a $1 million interest-free demand loan at a 4% AFR generates roughly $40,000 in deemed gifts a year, well past the exclusion.

For gift loans structured as term loans, the entire deemed transfer is calculated at origination using present value, so the whole gift tax consequence lands at once rather than spreading across the loan’s life.¹

The Small-Loan Safe Harbors

Section 7872 carves out two exceptions that keep most modest informal loans outside the rules.

The $10,000 De Minimis Rule

For gift loans between individuals, the imputed interest rules do not apply on any day the total balance between the two people stays at $10,000 or less. The same threshold covers compensation-related and corporation-shareholder loans.¹

One catch: the $10,000 exception disappears if the borrower uses the money to buy or carry income-producing assets like stocks, bonds, or rental property. Lending your child $8,000 interest-free for moving expenses is fine. Lending the same $8,000 to fund a brokerage account puts the full rules back in play.

The $100,000 Cap for Gift Loans

For gift loans between individuals with a 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. Net investment income generally means interest, dividends, royalties, and certain capital gains from investment property, minus investment expenses.⁶

If the borrower’s net investment income is $1,000 or less for the year, it is treated as zero, meaning no imputed interest is recognized at all. In practice, that turns the $100,000 exception into a full exemption for family loans where the borrower has little or no investment income.¹

Making It Look Like a Real Loan

The bigger practical risk with family lending is not miscalculating imputed interest. It is the IRS deciding the “loan” was never a loan at all. If there was no genuine expectation of repayment, the whole principal can be recharacterized as a gift, and gift tax applies to the full amount instead of just the interest shortfall.

Protecting the arrangement means treating it like an arm’s-length transaction from day one. Use a written promissory note. State the loan amount, an interest rate at or above the applicable AFR, a fixed repayment schedule, and a maturity date. The borrower should actually make the payments, and both parties should keep records. Collateral helps but is not always required.

What sinks these arrangements is informality: a handshake, a vague promise of repayment “someday,” missed payments the lender never chases. The IRS asks whether a reasonable creditor would have made this loan on these terms. If the borrower had no realistic ability to repay, or if the lender ignored the schedule, the whole thing looks like a gift. A prearranged plan to forgive the loan year by year using the annual exclusion is a pattern examiners look for specifically.

Penalties for Missing the Rules

Skipping imputed interest reporting costs more than the tax itself. The accuracy-related penalty under 26 U.S.C. § 6662 adds 20% of the underpayment for negligence or a substantial understatement of income. An understatement is substantial when it exceeds the greater of $5,000 or 10% of the tax that should have appeared on the return.⁷

Interest on unpaid tax runs from the original due date until the balance is paid. The individual underpayment rate for the first quarter of 2026 is 7% per year, compounded daily.⁸ On a multi-year loan where imputed interest was never reported, accumulated penalties and interest can outrun the original tax owed.

Below-market loans between related parties are a known audit trigger, especially shareholder loans that resemble disguised dividends and large family loans without a documented repayment history. The IRS does not need to catch the issue in real time. Once it identifies the arrangement, it can reconstruct the forgone interest for every year the loan was outstanding.

1
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
2
Internal Revenue Service. Rev. Rul. 2026-9
3
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
4
Internal Revenue Service. Applicable Federal Rates (AFRs) Rulings
5
Internal Revenue Service. What’s New – Estate and Gift Tax
6
Office of the Law Revision Counsel. 26 USC 163 – Interest – Section: (d)(4) Net Investment Income
7
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
8
Internal Revenue Service. Interest Rates Remain the Same for the First Quarter of 2026