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 February 2026, it ranges from 3.56% on short-term loans to 4.70% on long-term loans, with the exact figure depending on the loan’s length and how often interest compounds.1Internal Revenue Service. Revenue Ruling 2026-3 Charging anything less triggers tax consequences for the lender, who has to report interest income they never actually collected.
The IRS publishes the rates in a revenue ruling each month before the month begins, and each tier lists four figures — annual, semiannual, quarterly, and monthly compounding — so the rate on your loan agreement should match however often interest compounds under the note.2Internal Revenue Service. Applicable Federal Rates Rulings
The Three Rate Tiers
Which rate applies depends entirely on the loan’s maturity. The statute sorts every debt instrument into one of three buckets:3Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
- Short-term (3 years or less): February 2026 rate is 3.56% with annual compounding.
- Mid-term (over 3 years, up to 9 years): February 2026 rate is 3.86% with annual compounding.
- Long-term (over 9 years): February 2026 rate is 4.70% with annual compounding.1Internal Revenue Service. Revenue Ruling 2026-3
Longer maturities carry higher minimums, mirroring the yield curve on government debt. A parent lending a child money for five years uses the mid-term rate; a 15-year private mortgage uses the long-term rate.
Term Loans vs. Demand Loans
A term loan has a fixed repayment date, and it locks in the AFR that was in effect when the loan was made. That rate stays put for the life of the loan even if the AFR moves later. A demand loan — one the lender can call in at any time — has no set maturity, so it uses the short-term AFR compounded semiannually, and the rate resets as short-term rates change.4Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates If short-term rates rise, the minimum interest on a demand loan rises with them.
What Happens If You Charge Less Than the AFR
The IRS does not ignore missing interest. Under the below-market loan rules, it calculates the gap between what the lender would have earned at the AFR and what the lender actually charged, then treats that gap as if the borrower paid it and the lender received it.5Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates This phantom amount is called imputed or forgone interest.
The Lender’s Tax Bill
The lender must report the forgone interest as ordinary taxable income, regardless of whether the borrower ever paid it. On top of that, the IRS treats the “missing” money as if the lender first gave it to the borrower, and how that transfer is classified depends on the relationship:
- Between family members: The forgone interest is treated as a gift from lender to borrower. It counts against the $19,000 annual gift tax exclusion per recipient or the $15,000,000 lifetime exemption.6Internal Revenue Service. Frequently Asked Questions on Gift Taxes7Internal Revenue Service. Whats New Estate and Gift Tax
- From employer to employee: Treated as compensation, subject to income tax and potentially payroll tax.
- From a corporation to a shareholder: May be recharacterized as a dividend.
The Borrower’s Side
Because the IRS treats the forgone interest as paid, the borrower may be able to deduct it — but only if the loan proceeds went to a deductible purpose. Loans used for a business or for investment can generate a deduction. Loans used for personal spending cannot. The borrower still gets the practical benefit of a below-market rate; they just cannot claim a deduction for interest they never actually paid on a personal loan.
Small-Loan Exceptions
Not every below-market loan drags the AFR into the picture. Two safe harbors handle the most common family situations.
The $10,000 Rule
If the total outstanding balance between lender and borrower never exceeds $10,000, the imputed interest rules do not apply. You can lend a child $10,000 at zero interest and owe nothing to the IRS on the arrangement. The exception disappears, however, if the borrower uses the money to buy or carry income-producing assets such as stocks, rental property, or a business interest. A parallel $10,000 exception exists for employer-employee loans and corporation-shareholder loans, and that version is disqualified only when tax avoidance is a principal purpose.4Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
The $100,000 Rule
For gift loans between individuals with balances at or below $100,000, the forgone interest reported by the lender is capped at the borrower’s net investment income for the year.4Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates If that net investment income — dividends, interest, capital gains, and similar returns — is $1,000 or less, it is treated as zero, so no imputed interest applies. A $100,000 interest-free loan to a family member with little investment income can be effectively tax-free for the lender. Once the balance crosses $100,000, the cap disappears and the full AFR-based imputed interest applies.
The IRS also exempts certain other loans from the below-market rules when the interest arrangement has no meaningful effect on federal tax liability. If a taxpayer structures a transaction specifically to exploit an exemption for tax avoidance, the IRS can recharacterize it and apply the imputed interest rules anyway.8eCFR. 26 CFR 1.7872-5T – Exempted Loans (Temporary)
Making the Loan Hold Up as a Loan
Charging the AFR is necessary but not sufficient. For the IRS to treat a private loan as debt rather than a disguised gift or compensation, the transaction has to look and behave like a real loan. The agency examines substance, not just paperwork, and weighs several factors:
- A written, signed promissory note stating the principal, interest rate, repayment schedule, and maturity date.
- An interest rate that meets or exceeds the AFR for the loan’s term as of the month the loan is made.
- A fixed maturity date and a regular payment schedule.
- An actual payment history. A loan that exists only on paper looks like a gift.
- A realistic ability to repay when the loan was made.
- Genuine collection efforts if the borrower falls behind.
Failing on one factor is not fatal, but the closer the arrangement looks to a casual family handoff with no real expectation of repayment, the more likely the IRS is to treat it as a taxable gift. Keep the signed note, cancelled checks or transfer records, and a running record of payments received.
A Related Rate for Estate Planning: Section 7520
If you’re researching the AFR for estate planning rather than a straight family loan, there’s a related benchmark to know. The Section 7520 rate, used to value annuities and interests in trusts such as Grantor Retained Annuity Trusts, equals 120% of the mid-term AFR rounded to the nearest two-tenths of a percent.9Internal Revenue Service. Section 7520 Interest Rates For January 2026, that rate is 4.6%.10Internal Revenue Service. Revenue Ruling 2026-2 It moves with the mid-term AFR, so the same monthly ruling that sets your loan’s floor also sets the hurdle rate for these trust structures.