Trust Loan Interest Rate Rules: AFR, Imputed Interest, and Gift Tax

The minimum interest rate on a trust loan is the Applicable Federal Rate (AFR) that the IRS publishes each month for the loan’s term. As of late 2025, those rates ran roughly 3.66% for short-term notes to 4.55% for long-term notes, and they move each month with Treasury yields.¹ Charge less than the AFR and the IRS treats the missing interest as if it had been paid anyway, which creates taxable income for the lender and, often, a taxable gift from the lender to the borrower.

Which AFR Applies to Your Loan

The IRS publishes three AFR tiers each month, each tied to the length of the promissory note. The rates are derived from average market yields on U.S. government obligations of comparable maturity.²

Short-term AFR applies to loans with a term of three years or less.
Mid-term AFR applies to loans with a term over three years but not exceeding nine years.
Long-term AFR applies to loans with a term over nine years.

For a term loan, the rate locks on the date the loan is made. Pick the AFR in effect that month and it stays fixed for the life of the note, regardless of where rates go afterward. That single-month decision is permanent, which is why loan closings are often timed to a favorable rate month. The IRS maintains a page linking to each month’s revenue ruling so you can confirm the exact rate for your closing month.³

Keep in mind the AFR is a floor, not a ceiling. If the borrower has weak credit or the loan is unsecured, charging only the bare AFR can undermine the argument that the transaction is arm’s-length, because a commercial lender would charge more.

Demand Loans Use a Different Rule

Demand loans have no fixed maturity date, so they don’t fit the short, mid, or long-term categories. The applicable rate is the federal short-term AFR, compounded semiannually, and it floats throughout the life of the loan.⁴ The imputed interest calculation then changes each period as the short-term rate moves.

To simplify annual reporting, the IRS publishes a blended annual rate that averages short-term rates across the calendar year. The blended rate for 2025 was 4.22%.⁵ If you hold a demand loan with a fixed principal balance for the whole year, you can use that single rate instead of running a month-by-month calculation.

What Happens If You Charge Less Than the AFR

When a trust loan carries a below-AFR rate, Section 7872 rewrites the economics as if the correct interest had been charged. Two consequences hit at the same time.

Imputed Interest Income

The gap between what the borrower actually pays and what the AFR would require is treated as if the borrower paid it and the lender received it. The lender owes income tax on that phantom interest even though no cash changed hands.⁴ For a trust lender, this shows up on Form 1041. For an individual lending to a trust, it lands on the personal return. The borrower is treated as having paid the interest and may qualify for a deduction if the loan proceeds funded something deductible, such as an investment.

This calculation runs every year the loan remains outstanding, based on the principal balance. On a large, long-running loan, the cumulative phantom income adds up quickly.

Gift Tax

For term loans, the gift tax hit arrives upfront. On the day the below-market loan is made, the lender is treated as having given the borrower a gift equal to the difference between the loan amount and the present value of all required payments, discounted at the AFR.⁴ On a large loan with a rate well below the AFR, the deemed gift can be substantial.

For demand loans, the forgone interest is treated as a gift on the last day of each calendar year the loan is outstanding. Either way, if the deemed gift exceeds the $19,000 annual exclusion for 2026, the lender must file Form 709.⁶⁷ Any amount over the annual exclusion chips away at the lender’s lifetime exemption, which stands at $15,000,000 per person for 2026.

If the IRS concludes the loan was never a real loan, the consequences get much worse. The entire principal can be recharacterized as a gift or a taxable distribution from the trust, not just the interest shortfall.

Small-Balance Exceptions

Two safe harbors sit inside the below-market loan rules, and both have caveats that matter for trust lending.

The first is a flat exception for gift loans directly between individuals where the total outstanding balance stays at or below $10,000. For those loans, the below-market interest rules don’t apply at all.⁴ Trust loans rarely stay that small, and a loan from a non-grantor trust to a beneficiary may not qualify at all, because the trust is not an individual.

The second is more useful. For gift loans between individuals where the aggregate outstanding balance does not exceed $100,000, the imputed interest for income tax purposes is capped at the borrower’s net investment income for the year.⁴ If the borrower’s net investment income is $1,000 or less, it is treated as zero, which effectively eliminates the imputed interest. The exception vanishes the moment the aggregate balance crosses $100,000, and it doesn’t apply if a principal purpose of the arrangement is avoiding federal tax. The “directly between individuals” language again limits how well this works for a trust lender.

Loans Between a Grantor and a Grantor Trust

A grantor trust is one the IRS treats as still owned by the grantor for income tax purposes. Under Revenue Ruling 85-13, a loan between a grantor and the grantor’s own trust is disregarded for income tax purposes, because the grantor is viewed as standing on both sides of the transaction. Interest payments create no taxable income and no deduction. The grantor is treated as lending to themselves.

The AFR still matters, though. Even when income tax drops out, the loan must charge at least the AFR to avoid gift tax consequences. The loan also needs genuine economic substance: proper documentation, a real repayment schedule, and actual payments. If the IRS decides it was never a real debt, the transferred assets can be pulled back into the grantor’s estate.

If the Loan Gets Forgiven

Forgiving a trust loan does not clear up the tax issues. It usually creates new ones.

Canceled debt is generally taxable as ordinary income to the borrower.⁸ An exception exists for amounts canceled as gifts: if a trust forgives a beneficiary’s loan and the forgiveness qualifies as a gift, the borrower does not recognize cancellation-of-debt income, because gifts are excluded from gross income.

That gift classification then triggers its own consequences. The forgiveness is treated as a gift from the lender, and if it exceeds the $19,000 annual exclusion, a gift tax return is required.⁶ Repeatedly forgiving accrued interest year after year is especially dangerous. The pattern signals that the original transaction was never a real loan, which can retroactively recharacterize the entire principal as a taxable gift or distribution.

Documentation That Backs Up the Rate

Getting the AFR right is necessary but not sufficient. If the IRS audits the arrangement and the paperwork looks thin, a compliant rate alone will not save it. The transaction has to look and function like a real loan from start to finish.

A Signed Promissory Note

Every trust loan needs a formal, signed promissory note executed before or at the time funds change hands. The note should state the principal amount, the fixed interest rate (referencing the AFR in effect), a specific repayment schedule with dates and amounts, and the maturity date. Both the borrower and the trustee sign. Vague terms like “to be repaid when convenient” invite recharacterization.

Actual Payments

The strongest promissory note means nothing if payments never happen. Regular, documented payments of principal and interest on the dates specified in the note are the single most convincing evidence that a real debt exists. Wire transfers or checks create a paper trail. Missed payments, informal deferrals, or balloon structures where nothing is paid for years undermine the whole arrangement.

Collateral

Collateral is not legally required but substantially strengthens the case. A real commercial lender would take security on a large loan, so a trust that lends a significant amount to a beneficiary without any security interest in real estate, investment accounts, or other identifiable assets looks less like a lender.

Borrower Capacity

Before making the loan, the trustee should document that the borrower has the income or assets to repay it. This mirrors what a bank would do and serves as evidence that the parties genuinely intended a debtor-creditor relationship. A loan to a borrower with no realistic ability to repay looks like a disguised gift regardless of the paperwork.

Penalties for Getting It Wrong

Beyond the imputed interest and gift tax, the IRS can impose accuracy-related penalties when a below-market loan causes an underpayment of tax. The standard penalty is 20% of the underpayment and applies when the taxpayer was negligent or substantially understated tax liability. For a gross valuation misstatement, the penalty doubles to 40%. The penalty does not apply if the taxpayer acted in good faith and had reasonable cause for the position taken, which is one more reason that documentation and professional advice are worth their cost.

Choosing the Right Rate

For most trust loans, the process is simple. Determine the loan term, look up the matching AFR for the month you plan to close, and set the interest rate at or above that number. The IRS publishes the rates in a revenue ruling near the end of each preceding month.³ For demand loans, use the short-term rate and track changes through the year, or use the blended annual rate published after year-end for simplified reporting.

People get into trouble when they treat the AFR as the only thing that matters. The rate is the minimum threshold for tax compliance, but a defensible trust loan also requires proper documentation, real payments, and a borrower who can actually repay. Skimp on any of those and the interest rate becomes irrelevant, because the IRS will argue there was never a real loan to begin with.

1
Internal Revenue Service. Revenue Ruling 2025-24
2
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Applicable Federal Rate
3
Internal Revenue Service. Applicable Federal Rates
4
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
5
Internal Revenue Service. Revenue Ruling 2025-13 – Table 6
6
Internal Revenue Service. What’s New – Estate and Gift Tax
7
Internal Revenue Service. About Form 709
8
Internal Revenue Service. Canceled Debt – Is It Taxable or Not?