To calculate imputed interest, find the Applicable Federal Rate (AFR) for the month your loan was made and the term category it falls into, apply that rate to the outstanding principal, then subtract any interest the borrower actually paid. The difference is the imputed interest the IRS expects you to report as income. Before running the math, though, check whether a statutory exception exempts your loan entirely, because two common safe harbors eliminate the calculation for many family loans.
Check the Exceptions Before You Calculate
Section 7872 of the Internal Revenue Code sets the imputed interest rules, and it carves out situations where the rules simply don’t apply. Working through these first can save you the whole exercise.
The $10,000 De Minimis Rule
For gift loans directly between individuals, Section 7872 does not apply on any day when the total outstanding balance of all loans between you and that borrower is $10,000 or less. One condition: the exception disappears if the borrower uses the money to buy or carry income-producing assets such as stocks or rental property. Lend your adult child $8,000 for car repairs and you’re outside the rules. Lend the same amount for a brokerage account and you’re back inside them.
The $100,000 Net Investment Income Cap
Gift loans between individuals that stay at or below $100,000 in total outstanding get a more forgiving rule. Instead of imputing interest at the full AFR, the amount treated as interest income to you 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 and you report nothing. Once total loans between you and the borrower cross $100,000, the cap is gone and the full calculation kicks in.
If neither exception applies, you’re calculating.
Find the Right Applicable Federal Rate
The AFR is the IRS’s benchmark for a fair-market interest rate, and it changes every month. The agency publishes updated rates through revenue rulings on its dedicated AFR page. Each ruling lists rates for annual, semiannual, quarterly, and monthly compounding, split across three term categories:
- Short-term: loans with a term of three years or less.
- Mid-term: loans with a term longer than three years but no more than nine years.
- Long-term: loans with a term longer than nine years.
Demand loans always use the short-term AFR because they have no fixed maturity. For reference, the short-term AFR for January 2026, compounded annually, was 3.63%.
Two details matter here. First, pull the rate for the month the loan was made if it’s a term loan, or the current period’s rate if it’s a demand loan. Second, the statute requires semiannual compounding for determining the discount rate, so use the semiannually compounded column unless your loan agreement specifies otherwise. A wrong month or wrong term category throws off every number downstream.
Demand Loan vs. Term Loan: Two Different Calculations
The IRS splits below-market loans into two types, and the split changes both what you calculate and when. A demand loan is any loan the lender can call due at any time. A term loan has a fixed repayment schedule or maturity date.
Demand Loan Math
For a demand loan, if your rate is lower than the AFR, the loan is below-market. The calculation resets each year using whatever the current short-term AFR happens to be, so the imputed amount can shift from one year to the next.
The formula is straightforward: multiply the outstanding principal by the current short-term AFR, then subtract the interest the borrower actually paid during the year. The remainder is your imputed interest.
Say you lend your brother $100,000 as a demand loan when the short-term AFR is 4%, and he pays you 1% interest. The IRS expects $4,000 in interest for the year. He paid $1,000. The imputed amount is $3,000, treated as a gift from you to your brother and as interest income to you. If the AFR drops to 3.5% next year, expected interest becomes $3,500 and the imputed figure recalculates.
Term Loan Math
Term loans work on a front-loaded calculation. On the day the loan is made, calculate the present value of all future payments (principal and any stated interest) using the AFR in effect that month, compounded semiannually, as the discount rate. If the loan amount exceeds that present value, the loan is below-market and the excess is treated as original issue discount. That excess gets spread across the life of the loan as imputed interest income to you.
Because the AFR is locked in on the origination date, a term loan’s total imputed interest is fixed upfront rather than recalculated each year. The tradeoff is complexity: the present-value discounting makes term loans harder to handle by hand, and loans above $100,000 or with irregular payment structures usually warrant a present-value calculator or a tax professional.
What the Imputed Amount Becomes Depends on the Relationship
The number you calculate is the same regardless of who’s on the other side of the loan. How it gets characterized isn’t.
- Family or gift loans: the forgone interest is treated as a gift from you to the borrower. You report the imputed amount as interest income, and the gift portion may count toward your annual gift tax exclusion or require a gift tax return.
- Employer-employee loans: the forgone interest is treated as additional compensation. The employer generally deducts it as a wage expense, the employee reports it as income, and payroll taxes apply.
- Corporation-shareholder loans: the forgone interest is treated as a distribution from the corporation to the shareholder, typically taxed as a dividend, with the shareholder deemed to pay that amount back as interest.
In every version, you (or the lending entity) pick up imputed interest income. The first leg of the transaction is what shifts, and it’s what makes an employer loan a payroll matter, a shareholder loan a dividend matter, and a family loan a gift tax matter.
Reporting the Imputed Interest
Once the number is calculated, it has to land on the right forms.
Form 1099-INT and Schedule B
You report the imputed interest as income. If the total imputed amount is $10 or more, issue a Form 1099-INT to document the interest the borrower is deemed to have paid you, then include that interest on Schedule B of your Form 1040 with any other interest income for the year.
Form 709 for Family Loans
For gift loans, the forgone interest counts as a gift. In 2026, the annual gift tax exclusion is $19,000 per recipient. If the imputed interest, combined with any other gifts to that same person during the year, tops $19,000, you must file Form 709. Filing doesn’t necessarily mean gift tax is owed, since the lifetime exemption absorbs most gifts, but the reporting obligation stands on its own.
Penalties for Skipping the Reporting
Failing to file a required Form 1099-INT, or filing one with incorrect information, triggers penalties under Section 6721. For returns due in 2026, the amounts scale by how late the correction comes:
- Corrected within 30 days: $60 per return.
- Corrected after 30 days but by August 1: $130 per return.
- Not corrected by August 1 or never filed: $340 per return.
- Intentional disregard: $680 per return with no maximum cap.
A separate but equal penalty applies under Section 6722 for failing to furnish the correct statement to the borrower, so a single missed 1099-INT can produce two penalties: one for the IRS copy and one for the recipient copy. Unreported imputed interest on your own return can also draw accuracy-related penalties plus interest on the underpaid tax. Informal family arrangements are the situations where lenders most often assume no one is watching, and they’re also the situations where the IRS applies these rules most literally.