How to Calculate Imputed Interest: AFR, Reporting, and Penalties

To calculate imputed interest, multiply the loan’s outstanding principal by the Applicable Federal Rate (AFR) that matches the loan’s type and term, then subtract any interest the borrower actually paid. The difference is what the IRS treats as interest income to the lender, even though no money changed hands. The mechanics differ depending on whether the loan is a demand loan (recalculated every year using the short-term AFR) or a term loan (calculated once at origination using present value), and both are governed by Section 7872 of the Internal Revenue Code.¹

When the Rules Apply to Your Loan

A loan is “below-market” whenever its stated interest rate falls below the AFR. For a demand loan, the comparison is to the short-term AFR. For a term loan, the test is whether the amount lent exceeds the present value of all scheduled payments discounted at the AFR.¹

Three categories of loans are covered:

Gift loans between individuals, where the forgone interest is in the nature of a gift.
Compensation-related loans between an employer and employee, or between a hiring party and an independent contractor.
Loans between a corporation and any of its shareholders.

Two thresholds may take your loan out of the calculation entirely. First, a $10,000 safe harbor applies to all three categories: if the total balance between the same two parties stays at or below $10,000 on any given day, the rules do not apply for that day. This safe harbor disappears if one of the main purposes of the arrangement is federal tax avoidance.¹

Second, gift loans get an additional break up to $100,000. When the balance stays at or below that figure, the imputed interest the lender must report for the year is capped at the borrower’s actual net investment income (dividends, interest, royalties, and similar returns, not wages or business income). If the borrower’s net investment income is $1,000 or less, it counts as zero, and no imputed interest applies for that year. So if you lend an adult child $80,000 interest-free and the child earns only $400 in investment income, the imputed interest is zero. Once the balance crosses $100,000, this cap disappears and you calculate on the full amount regardless of the borrower’s investment income.¹

Which Applicable Federal Rate to Use

The IRS publishes AFRs monthly in the Internal Revenue Bulletin as Revenue Rulings, in three tiers based on loan length:²

Short-term: loans with a term of three years or less.
Mid-term: loans with a term longer than three years but not longer than nine years.
Long-term: loans with a term longer than nine years.

Each monthly ruling gives four compounding options (annual, semiannual, quarterly, and monthly) so you can match the compounding schedule written into your loan agreement.³

Demand loans always use the short-term AFR, compounded semiannually. Because a demand loan has no fixed end date, the applicable rate can shift as new monthly AFRs come out. To simplify things, the IRS publishes a blended annual rate each year that you can use when a demand loan with a fixed principal has been outstanding for the entire calendar year.⁴ For a year in progress, use the monthly short-term AFRs for each period the loan was outstanding until the blended rate is published after year-end.

Term loans lock in the AFR at origination. Use the rate matching the loan’s total duration from the month the loan was made. For loans tied to a sale or exchange, you may use the lowest AFR from the three-month window ending with the month the binding written agreement was signed.³

Calculating a Demand Loan

The formula is direct:

Forgone interest = (Principal × short-term AFR) − Actual interest paid

Say you lend a sibling $50,000 on January 1 at zero interest, and the loan stays outstanding all year. Using the 2024 blended annual rate of 5.03%:⁴

$50,000 × 5.03% = $2,515 in forgone interest.

Because your sibling paid nothing, the full $2,515 is imputed. The IRS treats it as though you gave your sibling $2,515 (a gift) and your sibling immediately paid you $2,515 back as interest. You report the $2,515 as interest income, and the same $2,515 counts toward your annual gift tax exclusion for that person.¹

The forgone interest is treated as transferred on the last day of the calendar year. Report it in the tax year the loan was outstanding, not the year the loan was made or repaid, and rerun the calculation each year the loan continues.⁵

Calculating a Term Loan

Term loans use present value. Instead of recalculating annually, you determine the total imputed interest once, at origination, by comparing the amount lent to the present value of every payment the borrower owes, discounted at the AFR matching the loan’s duration.¹

Imputed interest = Amount loaned − Present value of all required payments

Suppose you lend a family member $50,000 for five years at zero interest, with the full $50,000 due at the end of year five. The mid-term AFR at origination is 4%, compounded annually. Discount the single future payment back to today:

Present value = $50,000 ÷ (1.04)⁵ = $50,000 ÷ 1.2167 = $41,096

Imputed interest = $50,000 − $41,096 = $8,904.

The entire $8,904 is fixed at origination and treated as original issue discount (OID).¹ You do not report the full $8,904 in year one, though. As the lender, you include portions of the OID as interest income across the life of the loan.

When a term loan carries periodic payments at a rate below the AFR, discount each payment (both interest and principal installments) back to the loan date using the AFR, sum those present values, and subtract that total from the amount lent. Anything with a nontrivial payment schedule is best handled in a spreadsheet or with tax software.

How the Imputed Amount Is Characterized

The imputed amount is always interest income on the lender’s side. The transfer running the other way, from lender to borrower, is characterized based on the relationship:

Gift loans: treated as a gift from the lender to the borrower. If the year’s total gifts to that person (imputed interest plus anything else) exceed $19,000 for 2026, you must file Form 709.⁶
Compensation-related loans: treated as additional wages paid to the employee. The employer reports it on the W-2, and it is subject to payroll taxes.
Corporation-shareholder loans: treated as a distribution from the corporation to the shareholder, typically taxed as a dividend to the extent of earnings and profits.

The same dollars then flow back to the lender as interest income.¹ The borrower may sometimes deduct the imputed interest (for example, if the loan proceeds went to investment use and the borrower itemizes), but deductibility turns on how the funds were used.

Reporting the Number

Individual lenders report imputed interest as taxable interest on Schedule B of Form 1040, along with any other interest income.⁷ For term loans with OID, the lender includes the portion of the OID allocable to the tax year, and if that year’s OID is $10 or more, a Form 1099-OID may need to be filed.⁸

When the loan is between a corporation and shareholder or an employer and employee, the payer may need to issue Form 1099-INT if the imputed interest totals $10 or more.⁹

Gift loans that push you past the annual exclusion require Form 709, the United States Gift Tax Return.¹⁰ Filing it does not necessarily mean tax is owed. It reports the gift and reduces your lifetime exemption. Form 709 is due on the same date as your individual return, typically April 15 of the following year.

Penalties for Getting It Wrong

Skipping imputed interest on your return can draw an accuracy-related penalty of 20% of the underpayment caused by negligence or a substantial understatement of income. A substantial understatement generally means the underreported amount exceeds the greater of 10% of the correct tax or $5,000.¹¹

If a required Form 709 goes unfiled, a separate failure-to-file penalty runs at 5% of the unpaid tax per month, up to 25%. For returns due after December 31, 2025, the minimum penalty for filing more than 60 days late is $525 or 100% of the unpaid tax, whichever is less. Reasonable cause can support a waiver.¹²

1
Office of the Law Revision Counsel. 26 USC 7872 Treatment of Loans With Below-Market Interest Rates
2
Internal Revenue Service. Applicable Federal Rates AFRs Rulings
3
Office of the Law Revision Counsel. 26 USC 1274 Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property – Section: Determination of Applicable Federal Rate
4
Internal Revenue Service. Rev Rul 2024-13
5
GovInfo. 26 USC 7872 Treatment of Loans With Below-Market Interest Rates
6
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 Including Amendments From the One Big Beautiful Bill
7
Internal Revenue Service. Instructions for Schedule B Form 1040
8
Internal Revenue Service. About Form 1099-OID Original Issue Discount
9
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
10
Internal Revenue Service. a href=”https://www.irs.gov/instructions/i709″ target=”_blank” rel=”noopener”>Instructions for Form 709
11
Office of the Law Revision Counsel. 26 USC 6662 Imposition of Accuracy-Related Penalty on Underpayments
12
Internal Revenue Service. Failure to File Penalty