Non-Interest Bearing Note: IRS Rules and Tax Consequences

A non-interest bearing note is a written promise to repay a fixed sum by a set date at a stated interest rate of zero, and while the paper says no interest is owed, federal tax law usually treats interest as having been charged anyway. The IRS calls this imputed interest, and it can create taxable income for the lender, deductible interest for the borrower, and gift, compensation, or dividend consequences depending on who the parties are. The face of the note may show zero, but the tax return rarely does.

How the Note Works

The document itself looks like any other promissory note. It identifies the parties, the face amount, the maturity date, and the repayment schedule. The only distinguishing feature is that the annual percentage rate is set at zero.

The face value and the economic value are not the same number. If you lend someone $50,000 today against a promise to repay $50,000 in five years with no interest, the future $50,000 is worth less than $50,000 in your hand right now. That gap between present value and face value is the real cost of lending money interest-free, and it behaves much like a zero-coupon bond, where the return is baked into the spread between what you pay in and what comes back at maturity.

Common Uses

These notes tend to appear where the parties already know each other and market returns aren’t the point.

Family loans, most often a parent lending an adult child money for a home or a business.
Employer-to-employee loans used as a retention or relocation benefit.
Seller financing on real estate, where the seller accepts deferred payment as part of the purchase price.
Intercompany transfers between related businesses, or between a closely held corporation and its shareholders.

The IRS looks at each of these settings differently, but the underlying concern is the same: a zero-interest loan moves economic value from lender to borrower, and the tax code wants that transfer accounted for.

Why the IRS Imputes Interest

Internal Revenue Code Section 7872 classifies any loan carrying interest below a set threshold as a “below-market loan” and fills in the missing interest at the Applicable Federal Rate.¹ The rule reaches gift loans, compensation-related loans, and loans between corporations and shareholders. Once imputed, the interest is treated as if the lender actually received it (creating income) and the borrower actually paid it (creating a possible deduction, or, in the family setting, a matching gift back the other way).

The Applicable Federal Rate, or AFR, is published monthly by the IRS as a revenue ruling.² The correct rate depends on the loan’s term, as defined in Section 1274(d):³ short-term for loans of three years or less, mid-term for loans over three and up to nine years, and long-term for anything longer. As of April 2026, the annual-compounding AFRs are roughly 3.59% short-term, 3.82% mid-term, and 4.62% long-term. Because they shift monthly, you use the ruling in effect for the month the loan is made.

Term Loans and Demand Loans Are Treated Differently

The distinction matters, and mixing them up is a common error. A demand loan has no fixed maturity, so the lender can call it at any time. Section 7872 treats foregone interest on a demand loan as transferred from lender to borrower and then paid back as interest on the last day of each calendar year, and the imputed amount is recalculated annually at the current AFR.¹

A term loan has a fixed repayment date. Here the IRS front-loads the tax picture: on the day the loan is made, the lender is treated as transferring a lump sum equal to the difference between the face amount and the present value of all required payments discounted at the AFR. The loan then carries original issue discount, which the borrower accrues as interest expense over the life of the note. For a family gift loan structured as a term loan, the full imputed transfer is deemed to happen upfront, which can push the lender past the annual gift exclusion in year one.

Exceptions That Spare Small Loans

Section 7872 carves out relief for smaller arrangements so that every casual family loan doesn’t turn into a reporting exercise.

If the aggregate outstanding balance between the same lender and borrower stays at or below $10,000, imputed interest rules do not apply at all. This covers both gift loans between individuals and compensation-related loans. Cross $10,001 and the exception disappears on the full balance.

For gift loans directly between individuals with balances above $10,000 but not exceeding $100,000, imputed interest is capped at the borrower’s net investment income for the year.¹ If that net investment income is $1,000 or less, it is treated as zero, meaning no imputation. The shelter falls away if a principal purpose of the arrangement is tax avoidance, or if the balance climbs past $100,000.

Property Sales Follow a Separate Rulebook

When a non-interest bearing note is used in a property sale, most commonly seller-financed real estate, Section 483 generally governs instead of Section 7872. Section 483 recharacterizes part of each deferred payment as interest using the AFR as the discount rate.⁴ It applies when payments come due more than six months after the sale and the contract runs longer than one year.

Two exceptions are worth flagging. Sales of property for $3,000 or less are outside the rule entirely. And for sales of land between family members, the imputed rate is capped at 6% compounded semiannually, provided total qualifying sales between the same individuals stay under $500,000 in a calendar year. When market AFRs run high, that 6% cap is a meaningful benefit.

Gift Tax Impact for Family Loans

Imputed interest on a family loan is treated as a gift from lender to borrower. If it (combined with any other gifts to that same person during the year) exceeds the annual exclusion, the lender must file Form 709. For 2026 the annual exclusion is $19,000 per recipient, or $38,000 for a married couple electing to split gifts.⁵

The lifetime side of the equation matters more this year than most. The lifetime gift and estate tax exemption, roughly doubled by the Tax Cuts and Jobs Act, is scheduled to revert to its pre-2018 level of $5 million adjusted for inflation starting in 2026.⁶ That is a sharp drop from the roughly $13.6 million exemption in 2024 and 2025. Every dollar of imputed interest counted as a gift eats into the smaller lifetime figure, so on a large family loan it is often cheaper to charge at least the AFR and avoid the imputation entirely.

What Happens If the Lender Forgives the Note

If the lender writes off the remaining balance, the borrower generally reports the forgiven amount as cancellation-of-debt income in the year of forgiveness.⁷ A borrower who assumed the note was a no-cost accommodation can be caught off guard by a tax bill on money they didn’t receive as cash that year.

Section 108 does allow the forgiven amount to be excluded from gross income in specific situations:

Debt discharged in a Title 11 bankruptcy case.
Discharge while the borrower is insolvent, up to the amount by which liabilities exceeded the fair market value of assets immediately before the discharge.
A seller’s reduction of a buyer’s debt on purchased property, which is treated as a price adjustment rather than income, provided the borrower is solvent and not in bankruptcy.

On a family note, forgiveness also counts as a gift from the lender, so the borrower’s income tax hit stacks on top of the lender’s gift tax exposure. Outright forgiveness of a sizable family note is one of the more expensive moves in combined tax cost.

Financial Statement Treatment

Books diverge from the tax return on these notes, and anyone reporting under U.S. GAAP needs to plan for that. Under ASC 835-30, a note with a term longer than one year is recorded at present value rather than face amount, using a market-based interest rate that reflects what the borrower would pay an unrelated lender for a similar loan. The spread between face and present value is booked as a discount, which is amortized as interest income (for the lender) or interest expense (for the borrower) using the effective interest method over the life of the note.

Short-term trade payables, security deposits, notes between a parent and its subsidiaries, and transactions where interest rates are set by government restrictions or tax attributes fall outside the present-value requirement.

The market rate used for GAAP will rarely match the AFR used for tax, so book interest and tax interest on the same note usually differ. Track them separately.

How to Avoid the Whole Problem

The cleanest path is to charge at least the AFR from the beginning. A loan set at exactly the AFR is not a below-market loan, so Section 7872 never applies, no interest gets imputed, and the gift tax filing that comes with imputation is off the table. On a modest loan the required payments are small; on a larger one, the AFR is still typically well below what a commercial lender would charge.

Failing to report imputed interest, or deducting interest that wasn’t properly imputed, can draw an accuracy-related penalty of 20% on the resulting underpayment for negligence or substantial understatement of income, plus interest from the original due date.⁸ Setting the rate correctly at the outset takes an hour. Fixing it after an audit takes a great deal longer.

1
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
2
Internal Revenue Service. Applicable Federal Rates (AFRs) Rulings
3
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments
4
Office of the Law Revision Counsel. 26 USC 483 – Interest on Certain Deferred Payments
5
Internal Revenue Service. What’s New – Estate and Gift Tax
6
Internal Revenue Service. Estate and Gift Tax FAQs
7
Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness
8
Internal Revenue Service. Accuracy-Related Penalty