You lend your daughter $80,000 for a house down payment. You tell her not to worry about interest — it's family. You shake hands and feel generous. What you may not realize is that the IRS just generated taxable income for you, possibly a gift, and a paper trail you never signed up for.
This is the strange world of Section 7872 of the Internal Revenue Code, the rule that treats a "below-market loan" as if interest were charged even when no money changed hands. The tax law calls the missing interest imputed interest or forgone interest, and it applies automatically — whether or not you intended a gift, and whether or not you ever heard of the rule.
The good news: once you understand how the mechanics work, avoiding the whole mess is usually as simple as writing one number into a promissory note. Here's how below-market loans are taxed, where the de minimis exceptions save you, and the mistakes that turn a kind gesture into an audit headache.
What Counts as a Below-Market Loan
A below-market loan is any loan that charges interest below the Applicable Federal Rate (AFR) — a set of minimum interest rates the IRS publishes every month. If you charge less than the AFR (including charging nothing at all), the loan is "below-market," and Section 7872 kicks in.
The rules apply to four common loan categories:
- Gift loans — loans where the lender's decision to forgo interest is "in the nature of a gift." This is the classic parent-to-child loan.
- Compensation-related loans — below-market loans between an employer and an employee, or between a client and an independent contractor.
- Corporation-shareholder loans — below-market loans between a corporation and its shareholders, in either direction.
- Tax-avoidance loans and a catch-all category for any other arrangement where the interest structure has a significant tax effect.
The category matters because it determines who is treated as transferring what to whom. In a gift loan, the forgone interest is treated as a gift. In a compensation loan, it's treated as wages. In a shareholder loan, it's treated as a dividend or a capital contribution. The income tax piece is the same in every case; the second transfer is what changes.
How Imputed Interest Actually Works
Section 7872 uses a two-step fiction. Each year, the forgone interest — the difference between what the AFR would have produced and what was actually charged — is treated as if it followed this path:
- The lender transfers the forgone interest to the borrower. Depending on the loan type, this transfer is a gift, compensation, or a dividend.
- The borrower immediately transfers it back to the lender as interest. This is deemed to happen on the last day of the calendar year.
The result, for a no-interest family loan, is that the parent (lender) has interest income they must report and pay tax on — money they never actually received. The child (borrower) is treated as having paid interest, which may or may not be deductible depending on how they used the loan proceeds (personal-use interest generally is not deductible; investment or business-use interest may be).
For a shareholder loan from a corporation, the same forgone interest becomes a taxable dividend to the shareholder and interest income back to the corporation. For a compensation loan, the employee picks up extra wages (subject to payroll tax) and the employer gets interest income plus, potentially, a compensation deduction.
The phantom nature of this income is what surprises people. You can have a tax bill on interest you generously chose not to collect.
Demand Loans vs. Term Loans
Section 7872 splits loans into two types, and they behave very differently.
A demand loan is payable in full whenever the lender asks for it. Most informal family loans are demand loans by default — there's no fixed maturity date. For demand loans, the imputed interest is recalculated every year using the blended annual rate, a single rate the IRS publishes each year that approximates the short-term AFR over the year. Because the rate resets annually, your imputed interest moves up and down with interest rates.
A term loan has a fixed repayment schedule. For term loans, you lock in the AFR for the month the loan is made, and that rate stays fixed for the entire life of the loan no matter what rates do afterward. There are three term-loan AFRs:
- Short-term AFR — loans of three years or less
- Mid-term AFR — loans over three years and up to nine years
- Long-term AFR — loans over nine years
This locking feature is a genuine planning tool. If AFRs are low when you make a long-term term loan, you fix that low minimum rate for years — useful for intra-family loans designed to transfer wealth efficiently.
The De Minimis Exceptions That Save Most People
Congress built two safety valves into Section 7872 so that small, ordinary loans don't trigger paperwork.
The $10,000 Exception
If the total outstanding balance of loans between two individuals stays at or below $10,000, the gift-loan imputed interest rules simply don't apply. The same $10,000 floor exists for compensation-related and corporation-shareholder loans.
Two important catches:
- For gift loans, the exception is lost if the borrower uses the loan proceeds to buy income-producing assets — stocks, bonds, or rental property. Lend your son $9,000 to buy a used car and you're fine; lend him $9,000 to buy dividend stocks and the exception disappears.
- For compensation and shareholder loans, the exception is lost if tax avoidance is one of the principal purposes of the loan.
The $100,000 Exception
This one is more generous and more nuanced. For gift loans between individuals where the total outstanding balance is $100,000 or less, the imputed interest the borrower is treated as paying — for income tax purposes — is capped at the borrower's net investment income for the year.
The practical effect is powerful:
- If the borrower's net investment income for the year is $1,000 or less, it's treated as zero — meaning no imputed interest income at all for the lender.
- A child who borrows $90,000 to buy a primary residence and has little or no investment income generally produces no taxable imputed interest for the parent.
One crucial limit: the $100,000 exception only caps the income tax consequences. It does not eliminate the gift tax side. The lender is still treated as making a gift of the full forgone interest at the AFR for gift tax purposes. For most families that's harmless, because the gift is small and falls within the annual gift tax exclusion — but it's not zero.
The Gift Tax Connection
When a gift loan does generate imputed interest, that interest is also a gift from lender to borrower. In 2026, the annual gift tax exclusion is $19,000 per recipient. So if a parent's below-market loan produces $2,500 of imputed interest for the year, that $2,500 counts against the parent's $19,000 exclusion for that child — leaving $16,500 of room for other gifts.
In most cases the imputed interest is small enough to disappear inside the annual exclusion, so no gift tax return is required. But large interest-free loans — say, $500,000 to help a child buy a business — can throw off enough imputed interest to require filing Form 709 and using part of the lifetime exemption. This is precisely why high-dollar family loans should carry a real interest rate at the AFR: charging the AFR eliminates the forgone interest, which eliminates the gift entirely.
Keeping Records That Hold Up
Whether the IRS respects your loan as a loan — rather than recharacterizing the whole transfer as an outright gift — often comes down to documentation. A genuine loan generally has:
- A written promissory note stating the principal, interest rate, and repayment terms
- An interest rate at or above the AFR for the month the loan was made
- A fixed maturity date (for term loans) or clear demand terms
- Actual repayments that occur on schedule, with a record of each payment
- A lender who has a realistic expectation of being repaid
When a loan has no note, no payments, and no maturity, the IRS can argue there was never a loan at all — making the entire principal a taxable gift. Good bookkeeping is your defense. Recording each loan, each scheduled payment, and the interest accrued in a clean ledger turns a vague family arrangement into a defensible transaction. Plain-text accounting tools make this easy: a separate account for the loan receivable, dated entries for every payment, and a clear interest accrual leave no ambiguity if anyone ever asks.
Common Mistakes to Avoid
Assuming "no interest" means "no tax." The most expensive misconception. The imputed interest rules apply automatically and do not care that you meant to be generous.
Forgetting the income-producing-asset trap. The $10,000 gift-loan exception vanishes the moment the borrower uses the money to buy investments. Always ask what the proceeds are for.
Treating a demand loan like a set-and-forget arrangement. Demand loans recalculate imputed interest every year at the blended annual rate. A loan you made years ago is still generating fresh imputed interest annually until it's repaid.
Using the wrong month's AFR. For a term loan, the relevant AFR is the one for the month the loan is made — not the month you happened to check the tables, and not the current rate.
Ignoring the gift tax side because the $100,000 exception applied. That exception only addresses income tax. The gift tax characterization survives.
No paperwork at all. Without a note and a record of payments, you risk losing the loan characterization entirely and converting the full balance into a reportable gift.
A Simple Fix: Charge the AFR
For all the complexity, the cleanest escape route is short. If you charge interest at or above the AFR for the right loan term and the right month, there is no below-market loan, no forgone interest, no imputed income fiction, and no gift. You report the interest you actually receive — real income on real cash — and the borrower may deduct it if their use of the proceeds qualifies.
AFRs are often low relative to commercial lending rates, so charging the AFR still gives a family borrower a far better deal than a bank. For meaningful loans — anything well above the $10,000 floor — writing the AFR into a promissory note and collecting the interest is almost always simpler and cheaper than navigating Section 7872's imputed-interest machinery year after year.
Keep Your Loans and Interest Organized from Day One
Whether you're lending to a family member, a shareholder, or an employee, the difference between a clean transaction and an audit problem usually comes down to records: a documented rate, a maturity date, and a tracked history of every payment and interest accrual. Beancount.io provides plain-text accounting that gives you complete transparency and control over your financial data — every loan receivable, every payment, and every interest entry in a format you can read, version, and audit yourself. Get started for free and see why developers and finance professionals are switching to plain-text accounting.
This article is general information, not tax or legal advice. Applicable Federal Rates change monthly and the rules around below-market loans are fact-specific — consult a qualified tax professional before structuring a significant loan.