Demand Loan: Definition and Tax Treatment Under IRC Section 7872

A demand loan is one the lender can call in at any time, and its tax treatment turns on a single rule: if the interest rate is below the short-term Applicable Federal Rate, the IRS acts as if the missing interest was paid anyway. Under IRC Section 7872, that shortfall — called forgone interest — is treated as interest income to the lender and, at the same moment, as a gift, wages, or dividend flowing from the lender to the borrower. For 2026, the short-term AFR sits around 3.59% annually, so any demand loan charging less than that can trigger imputed interest, even when no cash changes hands.¹

What Counts as a Demand Loan

The statute defines a demand loan as any loan the lender can require to be repaid in full at any time. That covers the classic handshake loan between family members and the open-ended credit line a company extends to its owner. It also reaches loans with an indefinite maturity and certain employer-employee loans whose favorable terms depend on the borrower’s continued work for the lender.²

What sets demand loans apart from term loans for tax purposes is the missing maturity date. Because a demand loan is treated as continuously renewable, the IRS measures its interest shortfall day by day against the short-term federal rate instead of applying a present-value calculation against a longer-term benchmark.

Which Demand Loans Trigger Imputed Interest

Section 7872 doesn’t reach every below-market loan. It targets four categories where a low rate would otherwise let the parties sidestep income, gift, or employment tax:

Gift loans between family members or friends where the lender charges little or no interest as a form of generosity.
Compensation-related loans between an employer and employee, or between a business and an independent contractor, where the interest discount effectively works as extra pay.
Corporation-shareholder loans, where without imputed interest the transfer could disguise a dividend or a capital contribution.
Any arrangement where dodging federal tax is a principal purpose of the interest terms.

A loan in any of these categories is “below-market” if the stated rate falls short of the AFR.³ A zero-interest loan is the obvious case, but a loan charging 1% when the AFR is 3.59% qualifies just as much.

Calculating the Forgone Interest

The IRS publishes Applicable Federal Rates monthly, broken down by loan duration and compounding frequency.⁴ For demand loans, the rate that applies is always the federal short-term rate, compounded semiannually.³

The forgone interest for any period is the interest that would have accrued at the AFR minus whatever the borrower actually paid. On a $50,000 interest-free demand loan with a short-term AFR of 3.59%, the annual forgone interest runs roughly $1,795. If the borrower were paying 1%, the forgone interest drops to the spread — about $1,295. Because the AFR updates regularly, the number can shift month to month, so keeping track of the outstanding balance and the applicable rate through the year matters.

How Each Side Is Taxed

Once the forgone interest for the year is figured, the IRS treats it as two back-to-back transfers happening on December 31.⁵ First, the lender is deemed to hand that amount to the borrower. The character of that transfer follows the relationship:

On a gift loan, it is a gift, potentially subject to gift tax.
On an employer-employee loan, it is compensation, reported on the W-2 and subject to payroll taxes.⁶
On a corporation-shareholder loan, it is a dividend to the shareholder.

Second, the borrower is deemed to pay that same amount right back to the lender as interest. The lender reports that as interest income, even though nothing actually moved. For individual lenders, it lands on Schedule B.

When the Borrower Can Deduct the Deemed Interest

The borrower’s side is thinner. Personal interest isn’t deductible, so if you borrowed from a parent to buy a car, the deemed interest payment gives you nothing on your return. If the loan proceeds went into investments, the imputed interest you’re treated as paying can qualify as investment interest, deductible up to your net investment income for the year. Anything above that carries forward.⁷

The $10,000 De Minimis Exception

Small loans get a pass. If the total balance between a lender and borrower stays at $10,000 or below, Section 7872 doesn’t apply. The exception covers gift, compensation-related, and corporation-shareholder loans.⁸

It operates day by day. On any date the combined balance between the parties is $10,000 or less, no imputed interest accrues. Lend your brother another $5,000 on top of an existing $8,000, and imputed interest starts running from that day. Let the balance fall back below the line, and the exception picks up again. The IRS doesn’t retroactively punish brief periods above the threshold, but the balance does need tracking.

One important carve-out on gift loans: the $10,000 exception disappears entirely if the borrower uses the proceeds to buy income-producing assets like stocks or rental property.⁸ The statute is closing an obvious door: a parent lending a child $9,000 interest-free to invest, with nobody reporting anything.

Gift Loans Between $10,000 and $100,000

Gift loans in this middle band get a partial break that catches people off guard. Instead of imputing interest at the full AFR, the amount treated as retransferred from borrower to lender is capped at the borrower’s actual net investment income for the year. So if a parent lends a child $80,000 interest-free but the child earns only $600 in dividends and interest that year, the imputed interest is treated as zero, because the statute rounds net investment income below $1,000 down to zero.³

This limitation vanishes the moment the aggregate loan balance crosses $100,000. Above that, the full AFR-based imputed interest applies regardless of the borrower’s investment income. The limitation also doesn’t apply if tax avoidance is a principal purpose of the loan, meaning a lender who structures an $80,000 loan specifically to help the borrower shelter investment income can lose the benefit.

Gift Tax Reporting on Forgone Interest

On a gift loan, the forgone interest counts as a gift from lender to borrower, so the annual gift tax exclusion applies. For 2026 that exclusion is $19,000 per recipient.⁹ On most family demand loans, the annual forgone interest falls well below that. A $200,000 interest-free loan at a 3.59% short-term AFR generates about $7,180 in forgone interest, with no gift tax return required.

Complications appear when the forgone interest stacks with other gifts to the same person. If you already gave your daughter $15,000 in cash during the year and the forgone interest on a family loan adds another $5,000, the combined $20,000 exceeds the exclusion. You’d file Form 709 to report the excess, though no tax is typically owed until you exhaust your lifetime exemption.¹⁰

Making Sure the IRS Treats It as a Loan

All of this assumes you actually have a loan. When money moves between family members, the IRS presumes a gift unless the lender can show a genuine expectation of repayment. If the “loan” gets reclassified, the full principal becomes a taxable gift in the year of the transfer — a far worse outcome than imputed interest.

Treat the arrangement like a real financial transaction from day one:

Put it in a written promissory note. Include the loan amount, an interest rate at or above the AFR, and a clear statement that the lender can demand repayment at any time.
Make actual payments. A note sitting in a drawer with no cash flowing back looks like a gift in disguise.
Check that the borrower can plausibly repay. Lending $200,000 to someone with minimum wage and no assets undermines the claim anyone expected the money back.
Don’t prearrange forgiveness. If the plan is to forgive the loan in annual chunks timed to the gift tax exclusion, the IRS may treat the whole amount as a gift from the start.

Skipping one element won’t necessarily kill the arrangement, but the more boxes you check, the harder it is for the IRS to challenge the loan’s legitimacy. A current balance ledger and records of every payment go a long way.

Penalties for Getting It Wrong

The most common problem is simply failing to report the imputed interest. If the IRS catches the omission, the accuracy-related penalty adds 20% on top of whatever tax was underpaid.¹¹ On a small imputed amount that’s manageable. On a large loan that went unreported for years, the compounding underpayments and penalties climb fast.

In rare cases involving willful evasion rather than honest mistakes, penalties turn criminal. A conviction under federal tax evasion law carries fines up to $100,000 for individuals and up to five years in prison.¹² That level of enforcement almost never touches ordinary family loans, but it explains why proper reporting matters, particularly for large loans between business owners and their companies, where the dollar amounts draw more scrutiny.

1
Internal Revenue Service. Rev. Rul. 2026-7
2
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
3
Office of the Law Revision Counsel. 26 US Code 7872 – Treatment of Loans With Below-Market Interest Rates
4
Internal Revenue Service. Applicable Federal Rates
5
GovInfo. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
6
Stanford Faculty Staff Housing. Tax Aspects Related to Imputed Income on Zero Current Interest Loans
7
Office of the Law Revision Counsel. 26 US Code 163 – Interest
8
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
9
Internal Revenue Service. What’s New – Estate and Gift Tax
10
Internal Revenue Service. Instructions for Form 709
11
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
12
Office of the Law Revision Counsel. 26 USC 7201 – Tax Evasion