What Is the Federal Short-Term Rate: AFR and Imputed Interest

The federal short-term rate is the interest benchmark the IRS publishes each month for debt instruments maturing in three years or less. For February 2026 it is 3.56 percent with annual compounding.¹ It’s one of three Applicable Federal Rates (AFRs) set under Internal Revenue Code Section 1274(d), and it does two jobs most taxpayers eventually run into: it fixes the minimum interest you must charge on a short-term private loan, and it drives the interest the IRS charges on unpaid taxes and pays on refunds.

How the Rate Is Set and Where to Find It

The Secretary of the Treasury determines the rate monthly by averaging market yields on outstanding U.S. government obligations with three years or less remaining until maturity.² Averaging daily yields over a one-month window smooths out market swings and produces a stable figure taxpayers can rely on. The mid-term rate covers maturities over three years but not more than nine; the long-term rate covers anything beyond nine. The maturity of the loan or debt instrument tells you which of the three applies.

The IRS publishes the updated numbers each month in a Revenue Ruling and keeps every ruling since January 2000 on its Applicable Federal Rates page.³ Each ruling breaks the short-term rate out by compounding frequency. Revenue Ruling 2026-3, for February 2026, shows:¹

Annual compounding: 3.56%
Semiannual compounding: 3.53%
Quarterly compounding: 3.51%
Monthly compounding: 3.50%

Use the compounding frequency that matches your loan’s payment schedule. Monthly payments call for the monthly rate; a single annual payment calls for the annual rate.

Minimum Interest on a Private Loan

If you lend money to a family member or friend, the IRS expects the loan to carry at least the AFR for its term. For loans of three years or less, that floor is the federal short-term rate. Charge less, or nothing, and Section 7872 treats the gap between what you charged and what the AFR would have produced as “foregone interest.”⁴

The IRS then splits that foregone interest into two fictional transfers. First, the lender is treated as having given the borrower a gift (or compensation, or a shareholder distribution, depending on the relationship). Second, the borrower is treated as having paid that same amount back to the lender as interest. The lender must report the imputed interest as income even though no cash changed hands, and the gift portion counts against gift-tax thresholds.

Section 7872 reaches four categories of below-market loans:⁵

Gift loans between individuals, where the foregone interest is treated as a gift.
Compensation-related loans between an employer and employee, or between a service recipient and an independent contractor.
Corporation-shareholder loans between a corporation and any of its shareholders.
Tax-avoidance loans, meaning any below-market loan where dodging federal tax is a principal purpose of the interest arrangement.

The top federal gift-tax rate is 40 percent, so the stakes on a large mispriced loan can be real.⁶ The annual gift-tax exclusion for 2026 is $19,000 per recipient, which absorbs small amounts of imputed interest but not larger ones.⁷ A written promissory note stating the principal, repayment schedule, interest rate at or above the AFR, and maturity date protects both sides if the loan is ever examined.

Exceptions for Smaller Loans

Not every below-market loan triggers imputed interest. Section 7872 contains two safe harbors keyed to the total amount outstanding between the same borrower and lender.

The $10,000 Rule

If the total balance of all loans between the two individuals never exceeds $10,000 on any day, the imputed-interest rules simply do not apply. You can lend up to that amount interest-free with no tax consequences. The same $10,000 threshold exists separately for compensation-related and corporation-shareholder loans, but those two lose the exemption whenever avoiding federal tax is a principal purpose of the arrangement.⁴

One catch matters. The $10,000 gift-loan exception is not available if the borrower uses the money to buy or carry income-producing assets, such as stocks or a rental property.⁴

The $100,000 Cap

For gift loans where the total balance stays at or below $100,000, imputed interest is capped at the borrower’s net investment income for the year rather than calculated at the full AFR.⁴ If that net investment income is $1,000 or less, it is treated as zero, which effectively wipes out imputed interest for the year. Once the outstanding balance passes $100,000 the cap disappears and full AFR-based interest applies. The cap also does not apply to any loan where tax avoidance is a principal purpose.

Demand Loans vs. Term Loans

Whether the AFR locks in or floats depends on the loan type.

For a term loan (fixed repayment date), the AFR is set on the day the loan is made and stays put.⁴ The IRS compares the amount loaned to the present value of all payments due under the loan, discounted at that AFR. If the amount loaned exceeds that present value, the difference is treated much like original issue discount, with the lender picking up imputed interest as it accrues over the life of the loan.

For a demand loan (callable at any time), the rate floats. The IRS uses the short-term rate in effect during each period being measured, and foregone interest is calculated as of the last day of each calendar year.⁴ A demand loan’s imputed interest can rise or fall from one year to the next as the rate moves.

Reporting Imputed Interest

A lender reports imputed interest as interest income on Form 1040 (or 1040-SR). If total taxable interest for the year exceeds $1,500, Schedule B is also required.⁸

Private borrowers generally do not issue a Form 1099-INT to the lender. The Form 1099-INT instructions exclude interest paid on an obligation issued by an individual, and a typical private lender isn’t in the trade or business of lending.⁹ The lender still has to report the income regardless. Keep the promissory note, an amortization schedule, and the AFR that was in effect when the loan was made (or, for a demand loan, each year’s short-term rate).

IRS Interest on Back Taxes and Refunds

The federal short-term rate also determines how much interest the IRS charges when you owe and pays when it owes you. Section 6621 sets these rates by adding a fixed number of percentage points to the short-term rate.¹⁰

Individual underpayments: short-term rate plus 3 percentage points.
Individual overpayments (refunds): short-term rate plus 3 percentage points.
Corporate overpayments: short-term rate plus 2 percentage points, dropping to 0.5 points for the portion of any overpayment above $10,000.
Large corporate underpayments: short-term rate plus 5 percentage points, for any C corporation underpayment over $100,000.

For the first quarter of 2026 those formulas produce 7 percent for most individual underpayments and refunds, and 9 percent for large corporate underpayments.¹¹ Unlike the AFR, these rates reset quarterly, not monthly: the IRS uses the short-term rate from the first month of each quarter for the whole following quarter.¹⁰ Interest on an unpaid tax balance compounds daily, so a short delay can add up.

Seller-Financed Installment Sales

The rate can also show up when you sell property and finance the buyer yourself. If a seller-financed installment contract doesn’t charge adequate stated interest, the IRS may recharacterize part of the sale price as interest, which lowers your reported gain but raises interest income.¹²

The “test rate” for an installment sale is generally the lower of the AFRs in effect during the three-month period ending with the first month a binding written contract exists, or the three-month period ending with the month of the sale. For a contract with a repayment term of three years or less, that test rate is the federal short-term rate. A special rule caps the test rate at 9 percent, compounded semiannually, for seller-financed sales of $7,296,700 or less, other than new business-credit property.¹²

1
Internal Revenue Service. Revenue Ruling 2026-3
2
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
3
Internal Revenue Service. Applicable Federal Rates
4
Office of the Law Revision Counsel. 26 U.S. Code 7872 – Treatment of Loans With Below-Market Interest Rates
5
GovInfo. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
6
Internal Revenue Service. Instructions for Form 709 (2025)
7
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026, Including Amendments From the One, Big, Beautiful Bill
8
Internal Revenue Service. 1099-INT Interest Income
9
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
10
Office of the Law Revision Counsel. 26 USC 6621 – Determination of Rate of Interest
11
Internal Revenue Service. Quarterly Interest Rates
12
Internal Revenue Service. Publication 537 (2025) – Installment Sales