What Is AFR: Applicable Federal Rates, Tiers, and Section 7872

The Applicable Federal Rate is the minimum interest rate the IRS requires on private loans between related parties, such as family members, business partners, or a corporation and its shareholders. For January 2026, the rates run from 3.63% for short-term loans to 4.63% for long-term loans on annual compounding.¹ Charge less than the AFR on a private loan and the IRS treats the shortfall as if you had charged the full rate and handed the difference back to the borrower, which can produce income tax for the lender and gift tax exposure for a gift loan.²

The rate you need depends on how long the borrower has to repay and how the interest compounds. Both details are set by the promissory note, and both point to a specific number in the monthly revenue ruling.

The Three Rate Tiers by Loan Length

Section 1274(d) of the Internal Revenue Code splits AFRs into three tiers based on the loan’s term, and the cutoffs are strict:³

Short-term covers loans of three years or less.
Mid-term covers loans longer than three years but not more than nine.
Long-term covers loans running beyond nine years.

For January 2026, on annual compounding, that translates to 3.63% short-term, 3.81% mid-term, and 4.63% long-term.¹ A five-year family loan closed that month would need to carry at least 3.81% to satisfy the IRS.

The rate that matters for your loan is the one published for the month the loan is executed. The Treasury sets the following month’s rates during the current month, and the IRS publishes them as a revenue ruling.³ Once you lock in the rate for your loan’s month and tier, you don’t need to reset it later when new rulings come out.

Picking the Right Compounding Column

Each monthly ruling lists four rates for every tier: annual, semiannual, quarterly, and monthly compounding. Match the column to what your promissory note actually says. More frequent compounding produces a slightly lower stated rate because interest compounds more often; the January 2026 short-term rate, for instance, is 3.63% annual but 3.57% monthly.¹

The gap between columns looks small, but on a large balance over many years it adds up. If your note calls for monthly interest payments, use the monthly column, not the annual one. Reading from the wrong column can leave your stated rate a hair below the required minimum and pull the loan back into imputed-interest territory.

What Happens If You Charge Less Than the AFR

Section 7872 of the Internal Revenue Code governs below-market loans. When the interest you charge falls short of the AFR (or is zero), the IRS imputes interest: it treats the loan as if you had charged the full AFR and then transferred the difference back to the borrower.² Two tax consequences flow from that fiction.

The lender is treated as having received the imputed interest and owes income tax on it, even though no cash changed hands. On a gift loan, the same forgone interest is treated as a gift from lender to borrower. If the imputed gift to any one recipient exceeds the annual exclusion, which is $19,000 for 2026, the lender may need to file Form 709. Federal gift tax on taxable amounts above the exclusion runs up to 40%.⁴

Below-market loans in other related-party contexts get recharacterized to fit the relationship. Forgone interest on a company loan to an employee becomes compensation to the employee and interest income to the employer. Forgone interest on a corporation’s loan to a shareholder can be treated as a disguised dividend.²

Demand Loans vs. Term Loans

Timing depends on the loan’s structure. For demand loans (callable at any time) and gift loans, the forgone interest is treated as transferred and retransferred on the last day of each calendar year the loan is outstanding, and the calculation resets annually using the current AFR.²

Term loans that are not gift loans work differently. The entire excess of the loan amount over the present value of all required payments, discounted at the AFR, is treated as transferred on the date the loan is made.² The tax hit is front-loaded rather than spread across the life of the note.

Exceptions That Can Turn Off Section 7872

Two size-based exceptions inside Section 7872 keep small below-market loans from triggering imputed interest.

The $10,000 De Minimis Rule

For gift loans directly between individuals, Section 7872 does not apply on any day when the total balance owed between the two people is $10,000 or less. A parallel $10,000 threshold applies to compensation-related loans between employers and employees. The exception has an important carve-out: it does not apply to any gift loan directly attributable to the purchase or carrying of income-producing assets, such as stocks or a rental property.² A $9,000 interest-free loan a child uses to buy stock is not protected.

The $100,000 Net Investment Income Cap

For gift loans between individuals where the balance stays at or below $100,000, the imputed interest for income tax purposes is capped at the borrower’s net investment income for the year. A borrower with no net investment income has effectively zero imputed interest under this cap. It does not apply if one of the principal purposes of the interest arrangement is federal tax avoidance.²

Where to Find the Current Rate

The IRS publishes each month’s rates as a revenue ruling in the Internal Revenue Bulletin and posts them on a dedicated AFR page that also links to prior months.⁵ Each ruling contains tables for all three duration tiers and all four compounding frequencies. Rates are typically released before the start of the month they cover, so a loan closing planned for the following month can be priced in advance.⁶

To use the ruling, find the row that matches your loan’s tier and the column that matches your promissory note’s compounding frequency. That single number is the floor your stated interest rate has to meet or exceed.

A Related Rate for Estate Planning

One benchmark often confused with the AFR is the Section 7520 rate used to value interests in Grantor Retained Annuity Trusts, Charitable Lead Trusts, and similar vehicles. It is derived from the AFR (120% of the annual mid-term rate, rounded to the nearest two-tenths of a percent), but it is a separate figure with its own uses.⁷ If you are pricing a straightforward loan, the AFR is what you need; the 7520 rate belongs to a different set of transactions.

1
Internal Revenue Service. Revenue Ruling 2026-2 – Applicable Federal Rates for January 2026
2
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
3
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
4
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026, Including Amendments From the One, Big, Beautiful Bill
5
Internal Revenue Service. Applicable Federal Rates (AFRs) Rulings
6
Internal Revenue Service. Tax Code, Regulations and Official Guidance
7
Internal Revenue Service. Section 7520 Interest Rates