A below-market loan occurs when the interest rate on a loan is below the IRS’s minimum standard, known as the Applicable Federal Rate (AFR). The AFR is published monthly by the IRS and varies according to the loan’s term—short-term, mid-term, or long-term. When a loan’s interest rate is less than the AFR, the IRS imputes the difference as taxable interest income to the lender and may treat the shortfall as a gift to the borrower, often triggering gift tax implications.

The IRS introduced below-market loan regulations in the 1980s to prevent taxpayers from circumventing income and gift taxes by lending money at artificially low rates within families or related parties. These rules ensure that all economic benefits from loans are reported fairly for tax purposes.

For example, if you lend $100,000 to a family member at 2% interest when the AFR is 5%, the IRS imputes interest income based on the 5% rate. While you actually receive $2,000 in interest annually, the IRS considers you to earn $5,000, and the $3,000 difference is treated as a gift to the borrower. This gift must be reported and may reduce your gift tax exclusion.

Below-market loan rules are particularly relevant for:

  • Family and related-party loans
  • Low-interest employee loans
  • Loans to shareholders or business partners

Failure to follow these rules or properly document the loan agreement can result in unexpected tax liabilities and penalties. It’s important to always check the current AFR before making or accepting loans and to maintain clear written agreements.

Key IRS resources such as IRS Publication 550 and the IRS Applicable Federal Rates webpage provide authoritative guidance on these rules. For detailed explanations on imputed interest, visit our Imputed Interest page, and for the underlying interest rates, see Applicable Federal Rate (AFR).

Common misconceptions include thinking that interest-free loans avoid tax consequences, which is incorrect because the IRS will always impute interest. Also, below-market loan rules apply to loans of any size if the interest charged is below the AFR.

Tips for managing below-market loans:

  • Charge at least the AFR to avoid imputed interest and gift tax consequences.
  • Use formal loan agreements to clarify the terms.
  • Consult tax professionals when making large or complex loans, especially involving family or business partners.

By understanding below-market loans and their tax implications, borrowers and lenders can better plan to meet IRS requirements and avoid costly tax complications.

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