Do All Loans Have Interest? Exceptions, IRS Rules, and Reporting

Interest-free loans and taxes intersect in a way most people don’t see coming: even when no interest changes hands, the IRS can tax the lender as if it had. Under 26 U.S.C. § 7872, most below-market loans get an imputed interest rate applied to them, and the foregone interest becomes phantom income to the lender and, depending on the relationship, a gift, compensation, or dividend to the borrower.¹ Several exceptions blunt this for smaller and specific loans, but the default rule is that a 0% loan does not mean a 0% tax consequence.

When a 0% Loan Really Is Tax-Free

A few interest-free arrangements sit outside Section 7872 entirely. Federal Direct Subsidized Loans don’t accrue interest while the borrower is enrolled at least half-time or during the six-month grace period, because the Department of Education pays it. The subsidy is limited to undergraduate borrowers who demonstrate financial need; unsubsidized federal loans, graduate loans, and private student loans all accrue interest from disbursement.²

Promotional 0% APR financing from a retailer or auto manufacturer is a commercial transaction, not a gift or compensation, so the imputed-interest rules aren’t the concern. What matters there is whether the promotion is truly 0% or a deferred-interest offer where interest has been accruing from day one and gets tacked on retroactively if you miss the payoff deadline. The language distinguishes them: “0% intro APR for 12 months” is a true zero-rate deal, while “no interest if paid in full within 12 months” is deferred interest.³

Sharia-compliant financing avoids interest by structuring the deal as a purchase and resale at a disclosed markup, or as a joint venture with shared profits and losses. The client pays more than the underlying price, but the extra is tied to a trade or investment rather than time.

Everywhere else — the family loan, the personal loan between friends, the employer’s advance to an employee — Section 7872 is the rule to know.

How the IRS Treats Below-Market Loans

When a loan charges less interest than the Applicable Federal Rate (AFR), the IRS calculates the interest that should have been charged and treats that phantom amount as though it actually moved. The lender is taxed as if they received interest income. The transfer of value to the borrower is then characterized based on the relationship: a gift between family or friends, additional compensation between employer and employee, or a dividend between a corporation and its shareholder.¹

For a family loan, the mechanics are circular but real: the foregone interest is treated as a gift from lender to borrower, which is then “retransferred” back to the lender as interest income. The lender reports the phantom interest on Schedule B. The gift portion counts toward gift tax thresholds.

The Applicable Federal Rate

The AFR is published monthly and comes in three tiers based on the loan’s term:

Short-term, for loans of 3 years or less
Mid-term, for loans over 3 years but not over 9 years
Long-term, for loans over 9 years

These tiers are defined in 26 U.S.C. § 1274(d).⁴ As of January 2026, the monthly-compounded AFRs were 3.57% short-term, 3.74% mid-term, and 4.54% long-term. A 0% loan always sits below the AFR, so the full AFR gets imputed.

Demand Loans Versus Term Loans

The calculation runs differently depending on whether the loan is payable on demand or on a fixed schedule. For demand loans, the foregone interest is figured year by year using the short-term AFR in effect during each period, and it’s treated as transferred on the last day of each calendar year. For term loans, the IRS front-loads the hit: on the day the loan is made, the borrower is treated as receiving a lump sum equal to the difference between the amount borrowed and the present value of all required payments, discounted at the AFR locked in on that date.¹

Two Exceptions That Cover Most Family Loans

Section 7872 contains carve-outs that spare most casual family lending from any tax consequence at all.

The $10,000 De Minimis Rule

Gift loans between individuals are completely exempt from Section 7872 on any day the aggregate balance between lender and borrower stays at or below $10,000. No imputed interest, no gift tax reporting. The exception disappears, however, if the borrower uses the money to buy income-producing assets like stocks or rental property.¹

The $100,000 Net Investment Income Cap

For gift loans between individuals where the aggregate balance doesn’t exceed $100,000, the imputed interest the lender must report is capped at the borrower’s net investment income for the year. If that net investment income is $1,000 or less, it’s treated as zero, meaning no imputed interest applies at all. This is the rule that protects most parent-to-child loans for a first-home down payment or a car — situations where the child has little investment income.¹

Once the balance crosses $100,000, the protection ends and the full imputed interest rules apply regardless of the borrower’s income. The exception also doesn’t apply if one of the loan’s principal purposes is federal tax avoidance.

Employer Loans and the Relocation Carve-Out

When an employer lends to an employee below market, the foregone interest is treated as additional compensation. The employee has taxable income they never received in cash; the employer has a corresponding compensation expense.⁵

Relocation loans are the notable exception. Treasury regulations exempt certain relocation loans from Section 7872, but the conditions are specific. The loan must be secured by a mortgage on the employee’s new home near the new workplace, the employee must certify they expect to itemize deductions each year the loan is outstanding, and the proceeds must be used exclusively to buy the new residence. Bridge loans tied to selling a prior home also qualify if the amount doesn’t exceed the employee’s equity in the old property and is repayable within 15 days of that sale.⁶

One quirk to plan around: federal law prohibits employers from withholding tax on amounts treated as transferred under Section 7872. The imputed compensation won’t show up in regular paycheck withholding, so an employee with a below-market employer loan may need to adjust estimated tax payments to avoid an underpayment at filing.¹

Reporting the Phantom Interest

If you’re the lender on a below-market loan that doesn’t fit an exception, the imputed interest goes on Schedule B of Form 1040, the same line you’d use for interest from a bank account. IRS Publication 550 sets out how foregone interest on gift and demand loans must be reported as interest income to the lender.⁷

For gift loans between individuals, the amount the borrower is deemed to retransfer to the lender as interest is also treated as a gift from lender to borrower. If that imputed gift, combined with other gifts to the same person during the year, exceeds the annual gift tax exclusion ($19,000 for 2026), the lender must file a gift tax return on Form 709.⁸

What Happens If You Ignore the Rules

The most common mistake with a family loan is treating imputed interest as if it doesn’t exist. Lend a relative $150,000 at 0% and skip the phantom interest on your return, and you’ve underreported. The IRS can assess an accuracy-related penalty of 20% of the underpayment attributable to negligence or disregard of the rules, plus interest that runs on the penalty balance from the date it applies until it’s paid.⁹

The larger risk is reclassification. If the IRS examines a family loan and finds no promissory note, no repayment history, and no stated terms, it can treat the entire principal as a gift rather than a debt. A modest imputed-interest issue becomes a gift tax liability on the full amount. And if the gift wasn’t reported, the statute of limitations for assessment may never start running, giving the IRS an open-ended window to come back.

The practical takeaway: document the loan with a written note that states the parties, principal, payment schedule, consequences of default, and the interest rate (even if it’s zero), and keep records of actual repayments. The paperwork is what tells the IRS this is a loan rather than a disguised transfer, and it’s what lets you rely on the $10,000 and $100,000 exceptions with confidence.

1
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
2
Federal Student Aid. Top 4 Questions: Direct Subsidized Loans vs. Direct Unsubsidized Loans
3
Consumer Financial Protection Bureau. How to Understand Special Promotional Financing Offers on Credit Cards
4
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
5
Internal Revenue Service. Publication 525 (2025), Taxable and Nontaxable Income
6
GovInfo. 26 CFR 1.7872-5T – Exempted Loans (Temporary)
7
Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses
8
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026, Including Amendments From the One, Big, Beautiful Bill
9
Internal Revenue Service. Accuracy-Related Penalty