Interest-Free Loans and the AFR: Section 7872 Explained
Why a loan to a family member, an employee, or your own company at no interest still creates taxable interest, the published rates that set the floor, and the $10,000 and $100,000 exceptions.
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
A loan with no interest, or interest below the applicable federal rate the IRS publishes each month, is a below-market loan. Section 7872 treats the lender as having received the interest anyway and as having given the difference back to the borrower. Small loans and some family loans are excepted.
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What is imputed, and to whom?
| Loan | Lender treated as | Borrower treated as |
|---|---|---|
| Gift loan (family) | Receiving interest income and making a gift of the foregone interest | Paying interest (deductible only if it would otherwise be — investment or business use) |
| Compensation loan (employer to employee) | Receiving interest and paying wages | Receiving wages; paying interest |
| Corporation to shareholder | Receiving interest and paying a dividend | Receiving a dividend; paying interest |
| Shareholder to corporation | Receiving interest and contributing capital | Paying deductible interest |
| Tax-avoidance or other loans | Receiving interest and making a transfer characterized by the facts | Receiving the transfer |
The rate used is the applicable federal rate for the loan's term — short-term (not over three years), mid-term (over three and not over nine years), or long-term (over nine years). A term loan uses the rate in effect on the day the loan is made; a demand loan uses the short-term rate in effect for each period it is outstanding, so the imputed amount moves with the published rate.
What are the exceptions?
- $10,000 de minimis. Gift loans directly between individuals are ignored on any day the loans between them total $10,000 or less, unless the loan is directly attributable to buying or carrying income-producing assets. Compensation and corporate loans up to $10,000 are also ignored if tax avoidance is not a principal purpose.
- $100,000 gift loan limit. For gift loans directly between individuals totaling $100,000 or less, the interest the lender must report is capped at the borrower's net investment income for the year — and is zero if that income is $1,000 or less — unless tax avoidance is a principal purpose. A parent lending $90,000 to a child who has no investment income imputes nothing, though the gift tax rules still see a gift of foregone interest.
- Employee relocation loans and certain other loans have specific exceptions.
Why does it matter for business owners?
Owner loans to and from the company without interest create imputed dividends or wages, and the corporation's imputed interest income is taxable while the deemed dividend is not deductible. Family loans to fund a child's business or home purchase produce interest income the parent must report even if none is paid. And a loan without a note, interest, or repayment schedule risks being recharacterized as a gift or a distribution outright.
What does a compliant loan look like?
A written note, interest at or above the applicable federal rate (for a term loan, the rate for the month the loan is made; for a demand loan, a rate that keeps pace with the short-term rate), a repayment schedule that is followed, and for larger family loans a record of interest actually paid or reported. Charging the applicable federal rate — often far below bank rates — is enough to keep the loan outside Section 7872 entirely.
Frequently asked questions
Where do I find the applicable federal rate?
The IRS publishes it monthly in a revenue ruling, with short-, mid-, and long-term rates.
Does forgiving the loan later change the answer?
Forgiving principal is a gift (family) or compensation or dividend (business); imputed interest already reported stays reported.
Can I charge my child a lower rate than the AFR because they are family?
Any rate below the applicable federal rate triggers imputation, subject to the exceptions; charging the rate avoids it.
Does this apply to a loan to my Canadian relative?
Yes. The lender's U.S. treatment is the same; Canada has its own attribution and prescribed-rate rules on the other side.
Official sources
The IRS explains: “Each month, the IRS provides various prescribed rates for federal income tax purposes. These rates, known as Applicable Federal Rates (AFRs), are regularly published as revenue rulings.” — Internal Revenue Service, Applicable Federal Rates, https://www.irs.gov/applicable-federal-rates
The statute provides: “In the case of any gift loan directly between individuals, this section shall not apply to any day on which the aggregate outstanding amount of loans between such individuals does not exceed $10,000.” — Legal Information Institute, Cornell Law School, 26 U.S. Code § 7872 - Treatment of loans with below-market interest rates, https://www.law.cornell.edu/uscode/text/26/7872
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