IRC Section 7872: Below-Market Loans, Exceptions, and Reporting

Internal Revenue Code Section 7872 governs below-market loans by treating the interest a lender didn’t charge as if it had been paid anyway. When the section applies, the lender reports the shortfall as interest income, and that same amount is treated as flowing back to the borrower as a gift, wages, or a dividend, depending on the relationship. Both sides can owe tax on money that never actually moved.

Which Loans Get Pulled In

Section 7872 reaches five categories of below-market loans, and the definitions are broad enough to cover most sweetheart-rate arrangements.¹

Gift loans, where the forgone interest amounts to a gift. Most commonly, these run between family members or close friends.
Compensation-related loans between an employer and an employee, or between a business and an independent contractor. The shortfall is treated as additional pay.
Corporation-shareholder loans. A below-market loan from a corporation to a shareholder functions as a dividend; one going the other direction functions as a capital contribution.
Tax avoidance loans. Any below-market loan where one of the principal purposes of the interest arrangement is dodging federal tax. This category gives the IRS wide authority to recharacterize arrangements without economic substance.
Continuing care facility loans made under a qualifying continuing care contract. These are sheltered up to an inflation-adjusted limit (originally $90,000 in 1986) if the lender or the lender’s spouse is at least 65.

A loan is “below market” if it is a demand loan carrying interest below the applicable federal rate, or a term loan where the amount lent exceeds the present value of all required payments discounted at that federal rate.¹

Demand Loans and Term Loans Are Taxed Differently

Whether the loan is callable at any time or locked in for a set period controls both the timing and the shape of the tax hit.

A demand loan generates imputed interest year by year. On December 31, the lender is treated as having transferred the interest shortfall to the borrower, and the borrower is treated as having handed that same amount back as interest.² Because the applicable federal rate changes monthly, the imputed amount can vary year to year.

A term loan is different. The whole economic benefit is recognized upfront, on the day the loan is made. The lender is deemed to have transferred a lump sum equal to the loan’s face value minus the present value of all required payments, discounted at the AFR in effect when the loan was signed.² The loan then carries original issue discount, which the lender picks up in income over the life of the note. That front-loaded treatment is why term loans can produce a bigger year-one tax hit than a demand loan of the same size.

The $10,000 De Minimis Exception

Small loans are spared. Section 7872 does not apply to gift loans between individuals on any day the combined outstanding balance between the same two people stays at or below $10,000. The same $10,000 threshold applies separately to compensation-related and corporation-shareholder loans.¹

The rule sounds simple. It isn’t. The cap is measured daily and applies to the aggregate of all loans between the same parties, so splitting a $15,000 loan into two $7,500 notes does not keep you under. Married couples count as one person, which means a $6,000 loan from you and a $6,000 loan from your spouse to the same borrower adds to $12,000 and breaks the exemption.²

The exception also vanishes if the borrower uses the proceeds to buy or carry income-producing assets like stocks or rental property. In that case, interest is imputed no matter how small the loan. And the exception never applies where tax avoidance is a principal purpose of the arrangement.

The $100,000 Gift Loan Exception

Gift loans between individuals get a second layer of relief when the combined outstanding balance stays at or below $100,000. Under this rule, the imputed interest the borrower is treated as paying the lender in any year cannot exceed the borrower’s net investment income for that year.² Net investment income generally covers interest, dividends, capital gains, and similar returns.

The result is a real benefit for borrowers who don’t hold much in the way of investments. If your brother lends you $80,000 interest-free and you have no dividends, interest, or capital gains that year, the imputed interest for income tax purposes is capped at zero. If the borrower’s net investment income for the year is $1,000 or less, the statute treats it as zero outright.²

When multiple gift loans are outstanding, net investment income is allocated among them proportionally. The $100,000 cap disappears on any day the aggregate balance between borrower and lender crosses $100,000, and it never applies to loans with a tax avoidance purpose. Also worth flagging: the cap limits only the income tax consequences. Gift tax on the forgone interest is a separate analysis.

Calculating the Foregone Interest

Foregone interest is the difference between what the borrower would owe at the applicable federal rate and what the borrower actually pays.¹ Picking the right rate is a function of the loan type and its term.

The IRS publishes applicable federal rates monthly, sorted into three tiers:

Short-term, for loans of three years or less.
Mid-term, for loans over three years but not more than nine.
Long-term, for loans over nine years.

For a term loan, you lock in the AFR from the month the loan was made and use it for the life of the note. The statute defaults to semiannual compounding, though the monthly revenue rulings also publish annual, quarterly, and monthly equivalents. For a demand loan, the applicable rate is the federal short-term rate, which can shift each month. For reference, the short-term AFR for February 2026 was 3.56% with annual compounding.³

To spare taxpayers the monthly tracking, the IRS publishes a blended annual rate each year that averages the short-term rates across all twelve months. Anyone with a demand loan outstanding for the full year can use that single rate.

How to Report the Imputed Interest

The lender in every scenario reports the foregone interest as interest income. When interest income exceeds $1,500 for the year, Schedule B of Form 1040 is required.⁴ What the borrower does depends on the category:

For a gift loan, the forgone interest is a gift from lender to borrower. If it plus other gifts to that recipient exceeds the annual gift tax exclusion ($19,000 per recipient for 2026), the lender may need to file Form 709.⁵
For a compensation-related loan, the employer reports the imputed interest as wages on Form W-2, and the amount is subject to Social Security and Medicare taxes.
For a corporation-shareholder loan, the imputed interest is typically a dividend to the shareholder, reported on Form 1099-DIV. If the IRS views the loan as lacking economic substance, it can reclassify the whole balance as a constructive dividend.

One detail catches employers off guard. Even though compensation-related below-market loans create deemed wage payments, the statute expressly forbids withholding income tax on those imputed amounts.¹ The same no-withholding rule applies to term loan deemed transfers. The employee still owes the tax and should plan for a larger filing-time bill or adjust estimated payments.

Penalties for Getting It Wrong

Leaving imputed interest off a return exposes the taxpayer to the accuracy-related penalty under IRC Section 6662, which adds 20% to the underpayment.⁶ The IRS runs automated matching between what the lender reports as interest received and what the borrower reports as interest paid. Mismatches generate notices with no auditor needed.

Deliberate evasion is worse. Tax evasion under IRC Section 7201 is a felony carrying up to five years in prison, along with fines and back taxes with daily-compounded interest from the original due date.⁷

Records to Keep

The IRS asks taxpayers to retain records supporting a return for at least three years from the filing date.⁸ For a below-market loan, that means the signed loan agreement, the worksheets used to compute annual imputed interest, and documentation of the AFR you used. If the balance moved during the year, daily balance records are what prove you stayed inside the $10,000 or $100,000 threshold.

Loans that span multiple tax years create obligations for every year they remain open, so holding the underlying documents until three years after the return for the loan’s final year is the safer approach. Without organized records, defending a de minimis position during an audit becomes your word against the IRS’s math.

1
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
2
Office of the Law Revision Counsel. 26 U.S. Code 7872 – Treatment of Loans With Below-Market Interest Rates
3
Internal Revenue Service. Rev. Rul. 2026-3
4
Internal Revenue Service. 2025 Schedule B (Form 1040)
5
Internal Revenue Service. Instructions for Form 709
6
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
7
Internal Revenue Service. Tax Crimes Handbook
8
Internal Revenue Service. How Long Should I Keep Records