The IRS Minimum Interest Rate for Family Loans (AFR Explained)

Most people lending money worry about charging too much interest. With a family loan, there is a quieter risk waiting at the opposite end of the scale. Charge too little, or charge nothing at all, and the IRS may decide to treat your generosity as if you had charged interest anyway, then tax you on income that never landed in your pocket. The rule that governs this is the applicable federal rate, almost always shortened to AFR, and it is the floor the tax code expects a real loan to clear. Understanding it before you lend to someone you love is what keeps a kind gesture from turning into an unexpected line on your tax return.

What the Applicable Federal Rate Is

The AFR is a minimum interest rate the IRS publishes every single month. Think of it as the dividing line between what the tax code treats as a genuine loan and what it suspects is really a gift dressed up as a loan to avoid tax. There are three tiers, set by the length of the loan: the short-term rate covers loans up to three years, the mid-term rate covers loans over three years and up to nine, and the long-term rate covers loans beyond nine years. Each month the IRS sets a figure for each tier, and the rates are generally low, typically well beneath what a bank would charge, because they track the government own cost of borrowing rather than a commercial lending rate. That low level is good news, because it means clearing the floor costs your borrower very little.

Why Charging Below the AFR Creates a Problem

If you lend a meaningful sum to a family member and charge less than the AFR, the IRS can apply what it calls imputed interest. In plain terms, it pretends you charged the AFR even though you did not, calculates the interest you "should" have collected over the life of the loan, and can then tax you on that phantom income, money you never actually received. To add insult to it, the interest you chose not to charge can also be treated as a gift you made to the borrower, which pulls the arrangement into the gift tax rules as well. So the lender who generously charges zero interest can end up in the worst of both worlds: taxed on interest income that never existed, while also having made a reportable gift. The rule is counterintuitive precisely because the generous choice is the one that triggers it.

The De Minimis Exceptions That Protect Small Loans

The rules are not designed to punish small, neighborly loans, and there are exceptions that keep most modest lending out of trouble. Loans below a low dollar threshold are generally exempt from the imputed-interest rules entirely, so helping a relative with a small sum does not drag you into AFR territory at all. A separate, somewhat higher threshold limits the imputed interest to the borrower actual net investment income, which for a typical borrower with little or no investment income often reduces the imputed amount to nothing. The practical takeaway is reassuring: a small loan to help a family member is almost always fine to make interest-free, while it is the large, long-term, zero-interest loan where the AFR genuinely matters and where ignoring it can cost you.

How to Stay on the Right Side of It

The cleanest fix is also the simplest. Charge at least the AFR for the term of your loan, write that rate into a real promissory note, and you remove the imputed-interest problem at its source. Because the AFR is usually so low, meeting it asks very little of the borrower, often just a token amount of interest, and in exchange it transforms the loan from something the IRS might recharacterize into a clearly legitimate transaction that needs no second-guessing. The one practical step is to look up the current AFR for your loan term in the specific month you make the loan, since the rate resets monthly, and use that figure or a hair above it. Lock the rate in at origination and you do not have to revisit it.

Document It Like a Real Loan, Because It Is One

Meeting the AFR only helps if you can demonstrate that the loan was genuine in the first place, and that is where documentation does the heavy lifting. A written promissory note stating the principal, the interest rate, and the repayment schedule, paired with an actual record of payments being made, is what proves to the IRS that you treated this as a loan rather than a gift you are now calling a loan for convenience. A loan that exists only in memory and conversation is exactly the kind of arrangement the IRS is skeptical of, and skepticism is what invites the imputed-interest and gift-tax treatment you are trying to avoid. The note is your evidence. So a family loan really sits between two boundaries: stay under your state usury cap so you do not charge too much, and stay at or above the AFR so you do not charge too little, then document it and keep records. Our promissory note builder lets you set any interest rate, including one that meets the current AFR, and produces a documented, signed note with a repayment schedule, so your family loan looks like exactly what it is.

The two thresholds that decide whether any of this applies

Most family loans never reach the point of imputed interest, because the statute carves out two exceptions by size. Both are measured on the total outstanding between the same two people, not per loan.

Ten thousand dollars or less. For a gift loan directly between individuals, the rule does not apply on any day when the aggregate outstanding amount between them is $10,000 or less. Lend your brother $8,000 at no interest and there is nothing to impute. The exception falls away if the borrower uses the money to buy income-producing assets, so a no-interest loan for a rental property down payment does not qualify however small it is.

One hundred thousand dollars or less. Above $10,000 but at or under $100,000, interest is still imputed, but the amount treated as paid back to you is capped at the borrower's net investment income for that year. That is the phrase people get stuck on, and it is the taxpayer-friendly half of the rule. Net investment income means what section 163(d)(4) says it means: income from investments, things like interest and dividends, reduced by the expenses of earning it. It is not their salary.

There is a second floor inside that cap. If the borrower's net investment income for the year is $1,000 or less, it is treated as zero, and zero is what gets imputed to you.

Worth walking through the arithmetic. You lend your daughter $60,000 at no interest, and the AFR shortfall for the year works out to $2,400. If her only investment income is $300 of bank interest, that is under $1,000, so it counts as zero and you report nothing. If she earned $1,500 in dividends, your imputed interest is capped at $1,500 rather than the full $2,400. If the loan were $150,000 instead, the cap would not apply at all, and the whole $2,400 would be imputed.

That last point is the one to remember. Once the total outstanding between you passes $100,000, the net investment income ceiling disappears and the full shortfall is in play.

Sources

26 U.S.C. 7872, subsections (c)(2), (d)(1)(A), (d)(1)(D), and (d)(1)(E).