A demand note interest rate is almost always variable: a published benchmark like the Wall Street Journal Prime Rate or SOFR, plus a fixed margin negotiated between the parties. In early 2026, Prime sits at 6.75% and SOFR hovers around 3.65%, so a note written at “Prime + 2%” would carry roughly 8.75%. If the lender and borrower are related, the IRS sets a floor underneath whatever rate you pick: the note has to charge at least the short-term Applicable Federal Rate, which was 3.59% with annual compounding for April 2026, or the shortfall gets taxed as if it were a gift or compensation.
Why Demand Notes Run on Variable Rates
A demand note has no maturity date. The lender can call it tomorrow or leave it outstanding for years. That open-ended timeline makes a fixed rate awkward, because neither side knows how long the money will actually be in play. Lock in a low rate now and the lender loses ground if market rates climb; lock in a high one and the borrower gets crushed if rates fall.
Variable rates handle that uncertainty by adjusting automatically. Note language typically reads “Prime + 2.00%” or “SOFR + 300 basis points,” meaning the borrower pays whatever the benchmark reads on a given date, plus a fixed spread. The spread pays the lender for credit risk and for the fact that there’s no guaranteed repayment date.
Prime Rate and SOFR: The Two Benchmarks You Will See
The two indexes that show up in most demand notes are the Wall Street Journal Prime Rate and the Secured Overnight Financing Rate. They behave differently, and the choice affects how predictable interest costs will be for the borrower.
Wall Street Journal Prime Rate
Prime is the base rate that major commercial banks charge their strongest corporate borrowers. The Wall Street Journal surveys the 30 largest banks and updates its published rate when at least 23 of them move. Prime tracks the Federal Reserve’s target for the federal funds rate almost exactly, so a Fed decision flows through to Prime within days. In early 2026 the Prime Rate is 6.75%. Private demand notes between individuals often reference Prime because it’s simple, familiar, and easy to verify.
Secured Overnight Financing Rate
SOFR replaced LIBOR as the dominant U.S. dollar benchmark after regulators found LIBOR vulnerable to manipulation.1Alternative Reference Rates Committee. Transition from LIBOR It’s built from actual overnight borrowing costs backed by Treasury securities, which is harder to game. For demand notes, two versions matter: daily (spot) SOFR, which resets every business day, and Term SOFR, published by CME Group in one-, three-, six-, and twelve-month tenors. Term SOFR lets the borrower know the rate at the start of each interest period instead of recalculating every day. Over long stretches the two versions converge, though they can diverge sharply after an unexpected Fed move.
Some institutional demand note programs track the federal funds rate directly rather than Prime or SOFR.2BNY. Demand Notes: Beyond the Traditional Corporate Financing Playbook The specific benchmark matters less than making sure the chosen index is publicly available, clearly identified in the note, and verifiable by both sides.
The IRS Floor: Applicable Federal Rates for Related-Party Notes
When the lender and borrower are related, the rate stops being a purely private matter. Internal Revenue Code Section 7872 treats any loan charging less than the Applicable Federal Rate as a “below-market loan” and imputes the missing interest as though it had actually been paid.3Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates “Related” covers parents and children, employers and employees, corporations and their shareholders, and other pairings where a cheap loan could be used to shift wealth without paying tax.
The result is a double hit. The IRS treats the gap between the stated rate and the AFR as a transfer from the lender to the borrower (a deemed gift, dividend, or compensation depending on the relationship) and then a retransfer back as interest income to the lender. So the lender owes income tax on interest never collected, and the borrower may owe gift tax or income tax on a benefit never consciously received. The deemed transfer is treated as happening on the last day of each calendar year the loan is outstanding.3Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
Which AFR Applies
The AFR is published in three tiers: short-term for loans of three years or less, mid-term for over three but not more than nine, and long-term for anything longer.4Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property Because a demand note can be called at any time, the statute classifies it as short-term, and the applicable rate is the federal short-term rate compounded semiannually.3Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
The IRS publishes updated AFR tables in a revenue ruling at the start of each month. For April 2026, the short-term AFR was 3.59% with annual compounding and 3.56% with semiannual compounding.5Internal Revenue Service. Revenue Ruling 2026-7 These figures move every month.
The Blended Annual Rate Shortcut
To spare lenders from tracking a new rate each month for a single demand loan, the IRS publishes one blended annual rate every July that can be used for demand loans outstanding the full calendar year. The 2025 blended rate was 4.22%.6Internal Revenue Service. Revenue Ruling 2025-13 The 2026 blended rate will appear in a mid-year revenue ruling, typically in July. If you’re setting up a family demand note early in the year, the cleanest approach is to use the monthly short-term AFR until the blended figure comes out.
Small-Loan Exceptions That Skip the AFR Entirely
Not every family loan triggers imputed interest. Section 7872 carves out two exceptions based on loan size, and together they cover most casual lending between relatives.
Loans of $10,000 or Less
If the total balance between two individuals on any given day is $10,000 or less, the below-market loan rules simply don’t apply. You can lend a sibling $8,000 interest-free with no imputed income and no gift tax fallout. The same threshold applies to compensation-related and corporation-shareholder loans.7Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates One catch: the exception disappears if the loan proceeds are used directly to buy income-producing assets like stocks or rental property.
Gift Loans Between $10,001 and $100,000
For gift loans directly between individuals with a total outstanding balance at or below $100,000, the imputed interest treated as income to the lender is capped at the borrower’s actual net investment income for the year. If the borrower’s investment income for the year is under $1,000, it’s treated as zero, and no imputed interest applies at all.7Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates The exception doesn’t apply if one of the principal purposes of the interest arrangement is tax avoidance, and it drops away once the aggregate loans between the parties climb above $100,000.
In practice, these exceptions mean most small family loans don’t need AFR-level interest at all. The full imputed interest machinery really matters above $100,000, or on loans structured mainly to sidestep tax.
How the Rate Turns Into Actual Interest
Interest on a demand note accrues daily, because the lender could call the note at any moment and needs an exact number. The formula is straightforward: multiply outstanding principal by the annual rate, then divide by the days in the year. Commercial lending usually assumes a 360-day year (an ACT/360 convention), which produces a slightly higher effective cost than the 365-day year used in some consumer and government contexts.
Take a $50,000 note at 7.75%. On a 360-day basis, daily interest is $50,000 × 0.0775 ÷ 360 = $10.76, or $322.92 for a 30-day month. On a 365-day basis, the same loan yields $10.62 per day, or $318.49 per month. That gap compounds over the life of the note, so the day-count convention belongs in writing.
The note should also set a payment schedule, usually monthly or quarterly. When a payment lands, it’s applied first to any accrued but unpaid interest, and only the remainder reduces principal. Ignore that hierarchy and you get negative amortization, where unpaid interest folds into principal and the borrower ends up paying interest on interest. A clear record of how each payment splits between interest and principal keeps both sides straight at tax time.
Reporting the Interest to the IRS
The lender files Form 1099-INT for interest income of $10 or more paid by the borrower during the calendar year.8Internal Revenue Service. About Form 1099-INT, Interest Income On a related-party loan where imputed interest applies, the lender reports the imputed amount as income even though no cash moved. The borrower may be able to deduct the interest if the proceeds went to a qualifying use, such as investment; personal-use loans generally produce no deduction.
If forgone interest on a below-market gift loan pushes past the annual gift tax exclusion of $19,000 per recipient for 2026, the lender may need to file Form 709 to report the gift.9Internal Revenue Service. Whats New – Estate and Gift Tax For most family demand notes, the imputed gift stays comfortably inside the annual exclusion, but large loans at zero or minimal interest can cross the line. Form 709 is due by the tax filing deadline for the year of the gift.10Internal Revenue Service. About Form 709, United States Gift and Generation-Skipping Transfer Tax Return
Documenting the Rate So It Holds Up
A handshake loan between relatives is one of the fastest ways to create a tax problem. For the IRS to respect a demand note as real debt rather than a disguised gift, the deal has to look like something an unrelated lender would put in writing. Courts examining family loans look at whether a written instrument exists, whether the interest rate is adequate (at least the AFR), whether payments are actually being made, and whether both sides treat the debt as real.
At minimum, the written note should spell out:
- The principal amount being lent.
- The interest rate, including the specific benchmark index, the spread over that index, and the day-count convention (360 or 365).
- The payment schedule and the order in which payments are applied to interest and principal.
- How the lender will make demand and any grace period the borrower gets after notice.
- Default terms, including any bump in the rate. Default rates are commonly set 1% to 2% above the standard note rate.
Every payment, every rate adjustment tied to a benchmark move, and every piece of correspondence about the loan belongs in the file. That record is what keeps the IRS from recharacterizing the principal as a taxable gift, and what keeps a family disagreement from turning into a lawsuit nobody wins.