Section 7872(e)(2) Blended Annual Rate for Demand Loans

The Section 7872 blended annual rate is a single percentage the IRS publishes each year for calculating imputed interest on below-market demand loans between related parties. For 2025, the rate is 4.22%, published in Revenue Ruling 2025-13.¹ You multiply it by the loan’s average daily outstanding balance, subtract any interest the borrower actually paid, and the difference is the “foregone interest” the IRS treats as a taxable transfer between the parties.

The rate exists so you don’t have to track every monthly Applicable Federal Rate (AFR) change and compound the results semiannually. One number, one multiplication. But it only does that job for a demand loan that stays outstanding the entire calendar year.

When the Blended Annual Rate Applies

Section 7872 targets loans that charge interest below the AFR. For demand loans, “below-market” means any rate lower than the federal short-term rate. For term loans with a fixed maturity date, the test compares the loan amount to the present value of the future payments, and you’d use the AFR in effect when the loan was originated rather than the blended annual rate.

A demand loan is one the lender can call in full at any time. The definition also covers loans with indefinite maturities and certain loans tied to the borrower’s future performance of services. If your loan has a set repayment date, the blended annual rate isn’t the right tool.

The relationships that put a loan inside Section 7872 are:

Gift loans between family members or other individuals, where the below-market rate reflects a gift rather than a commercial deal.
Compensation-related loans between an employer and employee, or between a service recipient and an independent contractor.
Loans between a corporation and any of its shareholders.
Any below-market loan where avoiding federal tax is one of the principal purposes of the interest arrangement.

The common thread is a non-arm’s-length relationship where the low rate shifts value from one side to the other.²

Finding the Current Rate

The IRS releases the blended annual rate each year in a Revenue Ruling that comes out after the July short-term AFR is set. The 2025 rate is 4.22%. The 2024 rate was 5.03% and the 2023 rate was 4.65%.³ The 2026 figure will appear once the July 2026 short-term AFR is published.

The rate is included in the same Revenue Ruling as the monthly AFR tables, usually as the final table. The IRS’s Applicable Federal Rates page indexes those rulings chronologically.

Calculating Foregone Interest

Once you have the rate, the calculation is:

(Average daily outstanding balance × blended annual rate) − Interest actually paid = Foregone interest

That result is what Section 7872(e)(2) calls foregone interest, and it’s the amount the IRS treats as changing hands between the parties.²

Zero-Interest Loan

A parent lends a child $200,000 on January 1 with no interest charged, and the loan is still outstanding on December 31. Using the 2025 rate:

$200,000 × 4.22% = $8,440.

Because the borrower paid no interest, the full $8,440 is imputed. The IRS treats the parent as having given the child $8,440 (a gift), and the child as having paid it back to the parent as interest.⁴

Some Interest Charged

Same $200,000 loan, but the child pays 2% during the year, or $4,000 in real interest. The foregone interest drops to $8,440 − $4,000 = $4,440. Charging even a modest rate cuts the imputed amount considerably.

Partial-Year Loans

The blended annual rate assumes a loan outstanding the whole calendar year. If the loan was made or repaid mid-year, the simplest approach is to prorate: apply the rate to the average daily balance, then multiply by the fraction of the year the loan existed. A loan opened on October 1 would use 92/365 of the annual figure.

Exceptions That Can Reduce or Eliminate the Amount

The $10,000 De Minimis Exception

For gift loans directly between individuals, Section 7872 doesn’t apply on any day the total balance between the two of you is $10,000 or less. The exception is lost if the borrower uses the funds to buy or carry income-producing assets like stocks or a rental property.²

A parallel $10,000 threshold applies to compensation-related and corporation-shareholder loans, with a different disqualifier: the exception disappears if tax avoidance is one of the principal purposes of the interest arrangement.⁴

The $100,000 Gift Loan Cap

For gift loans directly between individuals where the total outstanding balance stays at or below $100,000, the imputed interest the lender must recognize is capped at the borrower’s net investment income for the year. Net investment income means interest, dividends, capital gains, and similar returns.

If the borrower’s net investment income for the year is $1,000 or less, the IRS treats it as zero, so no imputed interest at all. Consider a parent who lends a child $80,000 at zero interest. The rate produces $3,376 in foregone interest ($80,000 × 4.22%). If the child’s net investment income was $900 for the year, the imputed amount is zero and neither party reports anything. If the child instead had $2,500 of net investment income, the imputed interest would be capped at $2,500 rather than the full $3,376.⁵

The cap stops applying on any day the aggregate balance goes over $100,000, and it never applies if tax avoidance is one of the principal purposes of the arrangement.

Other Narrow Exemptions

Treasury regulations also exempt several specific loan types, including employee relocation loans and certain loans to qualified continuing care facilities where the lender or spouse is 65 or older, provided the arrangement isn’t structured to avoid federal tax.⁶

How the Imputed Amount Gets Taxed

Section 7872 uses a two-step fiction. The lender is treated as transferring the foregone interest to the borrower, and the borrower is treated as immediately paying it back as interest. The character of that first transfer depends on the relationship:

On a gift loan, the transfer from lender to borrower is a gift; the return transfer is interest income to the lender.
On a compensation loan, the employer-to-employee side is wages; the return side is interest income to the employer.
On a corporation-shareholder loan, the corporation-to-shareholder side is a dividend; the return side is interest income to the corporation.

Either way, the lender ends up with interest income to report.⁴ The borrower can potentially deduct the deemed interest payment, but only if it qualifies as investment interest or business interest; personal interest, which covers most family loans, is not deductible.

Reporting on the Lender’s Side

Individual lenders report the imputed interest on Schedule B of Form 1040. On a gift loan, the deemed gift portion has gift tax implications. For 2026, the annual gift tax exclusion is $19,000 per recipient.⁷ If the foregone interest stays under that number, the exclusion absorbs it and no gift tax return is required. If it exceeds the exclusion, you must file Form 709, though the $15,000,000 lifetime exemption for 2026 means you probably won’t owe actual gift tax.⁸ Filing 709 is how you document use of the lifetime exemption.

Reporting on the Borrower’s Side

If the deemed transfer is compensation, the borrower reports it as wages and the employer must include the amount on the W-2 with payroll tax withholding. If it’s a dividend from a corporation-shareholder loan, the corporation issues a Form 1099-DIV and the shareholder reports the dividend. On a gift loan, the borrower generally has nothing to report; the gift is the lender’s issue.

What Happens If You Skip This

The obligation doesn’t disappear if it’s ignored. If the IRS finds unreported imputed interest during an audit, the accuracy-related penalty is 20% of the underpayment, applied when the underpayment stems from negligence or from a substantial understatement (for individuals, an understatement exceeding the greater of 10% of the correct tax or $5,000).⁹

On a large loan the numbers get real. A $500,000 interest-free demand loan at the 4.22% rate produces $21,100 in imputed interest. If neither party reported it, the exposure on the lender’s side alone is material, and because Section 7872 affects both parties, the same examination can adjust both returns. The penalty can be waived for reasonable cause and good faith, but not knowing about a statute in place since 1984 is a weak argument. If you find you’ve been underreporting, filing amended returns for open years (generally the most recent three) is the cleanest fix.

Documentation to Keep

The IRS can also recharacterize a loan as a gift or disguised compensation if the arrangement doesn’t look like real debt. To hold the line, keep:

A written promissory note showing the principal, the interest rate (even if zero), the repayment terms, and whether the loan is payable on demand.
Bank statements or canceled checks documenting any principal or interest payments.
Your calculation worksheet: the average daily balance, the rate used, the imputed amount, and how you reported it.
The borrower’s net investment income figure, if you’re relying on the $100,000 cap.

Hold these for at least three years after filing the return that reports the imputed interest. If you’re leaning on the $100,000 cap or a de minimis exception, keep the supporting records for as long as the loan is outstanding plus the standard retention period.

1
Internal Revenue Service. Revenue Ruling 2025-13
2
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
3
Internal Revenue Service. Revenue Ruling 2024-13
4
Office of the Law Revision Counsel. 26 US Code 7872 – Treatment of Loans With Below-Market Interest Rates
5
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
6
eCFR. 26 CFR 1.7872-5T – Exempted Loans (Temporary)
7
Internal Revenue Service. What’s New — Estate and Gift Tax
8
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026, Including Amendments From the One, Big, Beautiful Bill
9
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments