What Is Imputed Interest? AFR, Exceptions, and Reporting

Imputed interest is the interest income the IRS treats you as having earned on a loan that charges little or no interest, even though the borrower never actually paid you a cent. When you lend money below a government benchmark rate, the tax code fills in the missing interest and taxes you on it. The same forgone amount is then treated as flowing back to the borrower as a gift, wages, or a dividend, depending on who they are to you. The rules live in Section 7872 of the Internal Revenue Code, and they catch far more everyday family loans than most people realize.¹

When the Rules Apply

Section 7872 targets four kinds of below-market lending. The most common is a gift loan between family members or friends, where the lender essentially isn’t charging interest because they don’t want to. The second is a compensation-related loan, typically from an employer to an employee, where cheap credit stands in for wages. The third is a corporation-shareholder loan, where a below-market rate can function as a disguised dividend. The fourth category covers various tax-avoidance arrangements the statute sweeps in.¹

A separate provision, Section 483, covers seller-financed sales. If you sell property and let the buyer pay over time without charging adequate interest, the IRS recharacterizes part of each payment as interest income to you. Section 483 kicks in when at least one payment is due more than six months after the sale and the contract runs longer than a year. Sales at $3,000 or less are exempt, and for land sales between family members the imputed rate is capped at 6% compounded semiannually on the first $500,000 of sales between the same parties in a calendar year.²

The Applicable Federal Rate Sets the Floor

The IRS publishes applicable federal rates each month.³ If your loan charges less than the AFR for the relevant term, the shortfall is imputed interest. There are three tiers under Section 1274(d):⁴

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 beyond nine years

For February 2026, the annual-compounding AFRs are 3.56% short-term, 3.86% mid-term, and 4.70% long-term.⁵ Charge at least the AFR for your loan’s term and the imputed interest rules simply don’t apply.

A Quick Example

Say you lend your brother $50,000 interest-free for two years. Two years is short-term, so at a 3.56% annual AFR the IRS treats roughly $1,780 per year as interest income to you. You’d also be treated as gifting that same $1,780 back to him each year. The gift piece falls well under the annual exclusion, so no gift tax return is triggered by that amount alone. But you still owe income tax on the phantom interest, and your brother gets no deduction because the loan is personal.

Demand Loans and Term Loans Are Timed Differently

A demand loan is any loan the lender can call at any time. Everything else, including a loan with a fixed repayment schedule, is a term loan. The distinction matters because timing works differently in each case.¹

On a demand loan, forgone interest is calculated for each calendar year the loan is outstanding and treated as transferred on the last day of that year. You report it annually, using the AFR in effect for each period.

Term loans front-load the hit. The entire imputed amount is recognized on the day the loan is made: the lender is treated as transferring a lump sum equal to the loan amount minus the present value of all scheduled payments, and that lump sum then accrues back into income over the life of the loan as original issue discount. On a long-term interest-free loan, that immediate recognition can produce a sizable tax bill in year one.

The $10,000 Exception for Small Loans

Section 7872 carves out a de minimis exception for gift loans between individuals and for compensation-related and corporation-shareholder loans. If the total outstanding balance between you and the other party stays at or below $10,000, the imputed interest rules don’t apply.¹

Two things trip people up here. The exception vanishes for gift loans if the borrower uses the money to buy income-producing assets like stocks, bonds, or rental property. And the $10,000 ceiling is aggregate. If you already lent your daughter $8,000 and then lend her another $3,000, the combined balance crosses the line and the whole thing is subject to the rules.

The $100,000 Cap Tied to Investment Income

For gift loans between individuals where the aggregate balance stays at or below $100,000, the imputed interest reportable for income tax purposes is capped at the borrower’s net investment income for the year.⁶ If the borrower’s net investment income for the year is $1,000 or less, it’s treated as zero, meaning no imputed interest at all on a loan under $100,000 to someone without meaningful investment returns.

This cap does not apply if tax avoidance is one of the principal purposes of the loan, and it does nothing to eliminate gift tax consequences on the forgone interest. Once the aggregate balance passes $100,000, the cap disappears and the full AFR-based amount applies.

The Gift Tax Angle People Miss

On a gift loan, the forgone interest is a gift from the lender to the borrower for federal gift tax purposes. The annual gift tax exclusion for 2026 is $19,000 per recipient.⁷ Most casual family loans produce imputed gifts small enough to fit inside that exclusion.

Larger loans can quietly break through it. A $500,000 interest-free loan at a 4% AFR generates $20,000 of imputed interest a year, which exceeds the $19,000 exclusion. That triggers a Form 709 filing obligation, and the excess counts against your lifetime gift and estate tax exemption, even though no actual cash ever changed hands.⁸ Missing Form 709 is its own compliance problem, separate from the income tax reporting, and it’s easy to overlook because nobody thinks of “not charging interest” as making a gift.

Can the Borrower Deduct It?

Because the IRS treats imputed interest as if it were actually paid, the borrower’s deduction depends entirely on what the money was used for.

If the borrower used the funds for business, the imputed interest is generally deductible as a business expense.
If the funds bought investments, the imputed interest is investment interest expense, deductible up to the borrower’s net investment income for the year, with any excess carried forward.⁹
If the loan is secured by a qualified residence, the imputed interest may be deductible as mortgage interest under the same limits as any other mortgage interest.
If the funds went to personal expenses, the imputed interest is not deductible.

That last category catches most family loans. The lender pays real income tax on interest they never collected, and the borrower gets nothing on the other side. Worth thinking through before you structure the loan.

Reporting and Penalties

As the lender, you report imputed interest on Schedule B of Form 1040, listing the borrower as the payer.¹⁰ You’ll never receive a 1099 for this income, so you calculate the amount yourself using the AFR that applied when the loan was made (or, for a demand loan, during each period it was outstanding). Compensation-related and corporation-shareholder loans can also trigger a Form 1099-INT filing obligation.¹¹

Skipping the reporting doesn’t make the income disappear. If the IRS finds unreported imputed interest, you face a 20% accuracy-related penalty on the underpayment under Section 6662, plus back taxes and interest.¹² On a large loan that ran for several years before discovery, the total can be steep.

Keep records of the loan amount, the date, the AFR that applied, and any interest the borrower actually paid. On larger loans, and on any term loan where the front-loaded original issue discount rules come into play, a tax professional is worth the fee.

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 USC 483 – Interest on Certain Deferred Payments
3
Internal Revenue Service. Applicable Federal Rates (AFRs) Rulings
4
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
5
Internal Revenue Service. Rev. Rul. 2026-3
6
Office of the Law Revision Counsel. 26 U.S. Code 7872 – Treatment of Loans With Below-Market Interest Rates
7
Internal Revenue Service. What’s New — Estate and Gift Tax
8
Internal Revenue Service. Instructions for Form 709
9
Office of the Law Revision Counsel. 26 U.S. Code 163 – Interest
10
Internal Revenue Service. Instructions for Schedule B (Form 1040)
11
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
12
Internal Revenue Service. Accuracy-Related Penalty