Below-Market Loans: Investment Taxes (2025 IRS Guide)

This guide covers “Below-Market Loans” within investment taxes. The following material presents the IRS treatment of this topic, including the qualifications, exceptions, and examples in the source section. Read the rules alongside the facts of your own situation before deciding what to report, deduct, or document.

Adapted from Publication 550 (2025), Investment Income and Expenses, published by the Internal Revenue Service. This guide retains the source edition’s years, amounts, deadlines, and examples. It is guidance for that edition, not a statement that the same figures apply to every tax year.

Context for these rules

This section discusses the tax treatment of different types of interest income.

In general, any interest that you receive or that is credited to your account and can be withdrawn is taxable income. Exceptions to this rule are discussed later.

Below-Market Loans

Generally, a “below-market loan” means any loan if (a) in the case of a demand loan, interest is payable on the loan at a rate less than the applicable federal rate, or (b) in the case of a term loan, the amount loaned exceeds the present value (using a discount rate equal to the applicable federal rate) of all payments due under the loan. (See Code section 7872 for details.) Section 7872 may consider the borrower to pay the lender any forgone interest and the lender to pay that foregone interest to the borrower. Thus, the lender may be compelled to recognize that foregone interest as income and the borrower may be able to deduct that foregone interest as an expense if the loan proceeds are used for business or investment. The nature of the forgone interest that section 7872 considers the lender to return to the borrower depends on the relationship between lender and borrower. It may be considered a gift, an investment, compensation, etc.

Loans subject to the rules.

The rules for below-market loans apply to:

• Gift loans,

• Compensation-related loans,

• Corporation-shareholder loans,

• Tax avoidance loans, and

• Certain loans made to qualified continuing care facilities under a continuing care contract.

A compensation-related loan is any below-market loan between an employer and an employee or between an independent contractor and a person for whom the contractor provides services.

A tax avoidance loan is any below-market loan where the avoidance of federal tax is one of the main purposes of the interest arrangement.

Forgone interest.

For any period, forgone interest is:

• The amount of interest that would be payable for that period if interest accrued on the loan at the applicable federal rate and was payable annually on December 31, minus

• Any interest actually payable on the loan for the period.

Applicable federal rate.

Applicable federal rates are published by the IRS each month in the Internal Revenue Bulletin. The Internal Revenue Bulletin is available through IRS.gov/IRB. You also can find applicable federal rates in the Index of Applicable Federal Rates (AFR) Rulings at IRS.gov/applicable-federal-rates.

See chapter 5, How To Get Tax Help, for other ways to get this information.

Rules for below-market loans.

The rules that apply to a below-market loan depend on whether the loan is a gift loan, demand loan, or term loan.

Gift and demand loans.

A gift loan is any below-market loan where the forgone interest is in the nature of a gift.

A demand loan is a loan payable in full at any time upon demand by the lender. A demand loan is a below-market loan if no interest is charged or if interest is charged at a rate below the applicable federal rate.

A demand loan or gift loan that is a below-market loan generally is treated as an arm's-length transaction in which the lender is treated as having made:

• A loan to the borrower in exchange for a note that requires the payment of interest at the applicable federal rate, and

• An additional payment to the borrower in an amount equal to the forgone interest.

The borrower generally is treated as transferring the additional payment back to the lender as interest. The lender must report that amount as interest income.

The lender's additional payment to the borrower is treated as a gift, dividend, contribution to capital, pay for services, or other payment, depending on the substance of the transaction. The borrower may have to report this payment as taxable income, depending on its classification.

These transfers are considered to occur annually, generally on December 31.

Term loans.

A term loan is any loan that is not a demand loan. A term loan is a below-market loan if the amount of the loan is more than the present value of all payments due under the loan.

A lender who makes a below-market term loan other than a gift loan is treated as transferring an additional lump-sum cash payment to the borrower (as a dividend, contribution to capital, etc.) on the date the loan is made. The amount of this payment is the amount of the loan minus the present value, at the applicable federal rate, of all payments due under the loan. An equal amount is treated as an OID. The lender must report the annual part of the OID as interest income. The borrower may be able to deduct the OID as interest expense. See Original Issue Discount (OID), later.

Exceptions to the below-market loan rules.

Exceptions to the below-market loan rules are discussed here.

Exception for loans of $10,000 or less.

The rules for below-market loans do not apply to any day on which the total outstanding amount of loans between the borrower and lender is $10,000 or less. This exception applies only to:

1. Gift loans between individuals if the gift loan is not directly used to buy or carry income-producing assets, and

2. Compensation-related loans or corporation-shareholder loans if the avoidance of federal tax is not a principal purpose of the interest arrangement.

This exception does not apply to term loans. The general below-market loan rules will continue to apply even if the outstanding balance is reduced to $10,000 or less.

Exception for loans to continuing care facilities.

Loans to qualified continuing care facilities under continuing care contracts are not subject to the rules for below-market loans for the calendar year if the lender or the lender's spouse is age 65 or older at the end of the year. For the definitions of qualified continuing care facility and continuing care contract, see Internal Revenue Code 7872(g)(4) and (h).

Exception for loans without significant tax effect.

Loans are excluded from the below-market loan rules if their interest arrangements do not have a significant effect on the federal tax liability of the borrower or the lender. These loans include:

1. Loans made available by the lender to the general public on the same terms and conditions that are consistent with the lender's customary business practice;

2. Loans subsidized by a federal, state, or municipal government that are made available under a program of general application to the public;

3. Certain employee-relocation loans;

4. Certain loans to or from a foreign person;

5. Gift loans to a charitable organization, contributions to which are deductible, if the total outstanding amount of loans between the organization and lender is $250,000 or less at all times during the tax year; and

6. Other loans on which the interest arrangement can be shown to have no significant effect on the federal tax liability of the lender or the borrower.

For a loan described in (6) above, all the facts and circumstances are used to determine if the interest arrangement has a significant effect on the federal tax liability of the lender or borrower. Some factors to be considered are:

• Whether items of income and deduction generated by the loan offset each other;

• The amount of these items;

• The cost to you of complying with the below-market loan rules, if they were to apply; and

• Any reasons other than taxes for structuring the transaction as a below-market loan.

If you structure a transaction to meet this exception and one of the principal purposes of that structure is the avoidance of federal tax, the loan will be considered a tax-avoidance loan, and this exception will not apply.

Limit on forgone interest for gift loans of $100,000 or less.

For gift loans between individuals, if the outstanding loans between the lender and borrower total $100,000 or less, the forgone interest to be included in income by the lender and deducted by the borrower is limited to the amount of the borrower's net investment income for the year. If the borrower's net investment income is $1,000 or less, it is treated as zero. This limit does not apply to a loan if the avoidance of federal tax is one of the main purposes of the interest arrangement.

Using the guidance

Keep the documents that establish the dates, amounts, and circumstances described above. References to other chapters, forms, worksheets, or earlier and later sections refer to the linked IRS publication. Check the full publication and its updates before relying on a rule for a different tax year or a situation not addressed here.

Sources and further reading

• Publication 550 (2025), Investment Income and Expenses: Investment Income — Interest Income — Below-Market Loans — Internal Revenue Service; 2025 edition.

The cited U.S. government text is in the public domain. Source accessed October 28, 2026. Fynoptic has organized this material for educational use and is independent of, and not endorsed by, the IRS.