Trust Loan Interest Rate Rules: AFR, Gift Tax, and Penalties

The minimum interest rate on a trust loan is the Applicable Federal Rate (AFR) that the IRS publishes each month for the loan’s term. As of late 2025, those rates ran from roughly 3.66% to 4.55% depending on how long the note lasts, and they move monthly with U.S. Treasury yields.¹ Charge less than the AFR and the IRS acts as if the interest were paid anyway: the lender picks up phantom income, and the shortfall is treated as a gift from lender to borrower. On a big loan, that is a serious tax bill for a paperwork problem.

Picking the Right AFR

The IRS publishes three AFR tiers each month, keyed to the length of the promissory note. The rates are derived from average market yields on U.S. government obligations of comparable maturity.²

Short-term AFR for loans of three years or less.
Mid-term AFR for loans over three years but not more than nine.
Long-term AFR for loans over nine years.

For December 2025, the annual-compounding AFRs were 3.66% short-term, 3.79% mid-term, and 4.55% long-term.¹ The IRS keeps a page linking to every month’s revenue ruling so you can find the exact rate for the month your loan closes.³

For a term loan, the rate locks on the date the loan is made and stays fixed for the life of the note. Whatever the AFR is that month is what you use, and later rate moves are irrelevant.

The AFR is a floor, not a ceiling. If the borrower has weak credit or the note is unsecured, charging only the AFR can actually cut against the argument that the loan is arm’s-length, because a commercial lender would demand more.

Demand Loans Follow a Different Rule

Demand loans have no fixed maturity, so they don’t fit the short, mid, or long-term buckets. The applicable rate is the federal short-term AFR compounded semiannually, and it floats over the life of the loan.⁴ The imputed interest calculation shifts each period as the short-term rate moves.

To make annual reporting less painful, the IRS publishes a blended annual rate that averages the short-term rates across the calendar year. The blended rate for 2025 was 4.22%.⁵ If the principal balance holds steady all year, you can use that one number instead of running a period-by-period calculation.

What Happens If You Charge Less Than the AFR

When a trust loan charges below-market interest, Section 7872 rewrites the transaction as if the correct rate had been charged. Two tax consequences arrive at once.

Phantom Interest Income

The gap between what the borrower actually pays and what the AFR would require is treated as if the borrower paid it and the lender received it. The lender owes income tax on interest that never showed up in the bank account.⁴ For a trust as lender, that lands on Form 1041; for an individual lending to a trust, it lands on the personal return. The borrower is deemed to have paid that same interest, and can deduct it if the loan proceeds funded something deductible.

This runs every year the loan is outstanding. On a large, long-running note, the cumulative phantom income adds up quickly.

Gift Tax

For a term loan, the gift hits on day one. The lender is treated as giving the borrower an immediate gift equal to the loan amount minus the present value of the required payments discounted at the AFR.⁴ On a big loan carrying a rate well under the AFR, that number can be substantial.

For a demand loan, the forgone interest is treated as a gift on the last day of each calendar year the loan is outstanding. Either way, if the deemed gift exceeds the $19,000 annual exclusion for 2026, the lender has to file Form 709.⁶⁷ Any amount above the annual exclusion reduces the lender’s lifetime exemption, which sits at $15,000,000 per person for 2026.

If the IRS decides the loan was never real to begin with, the fallout is worse. The entire principal can be recharacterized as a gift or a taxable distribution from the trust, not just the interest shortfall.

Loans Between a Grantor and a Grantor Trust

A grantor trust is one the IRS treats as still owned by the grantor for income tax purposes. Under Revenue Ruling 85-13, a loan between a grantor and their own grantor trust is disregarded for income tax purposes because the grantor stands on both sides. Interest payments create no income and no deduction. The grantor is effectively lending to themselves.

The AFR still applies. Income tax may be a non-issue, but the loan must charge at least the AFR to avoid gift tax consequences. And the loan needs real economic substance: proper documentation, a genuine repayment schedule, and payments that actually happen. If the IRS decides it was never a real debt, the transferred assets can be pulled back into the grantor’s estate.

Documentation Has to Match the Rate

The right rate is necessary. It isn’t sufficient. If the paperwork is thin or nobody ever makes a payment, an AFR-compliant rate won’t rescue the transaction.

Every trust loan needs a signed promissory note executed before or when the funds move. The note should state the principal, the fixed interest rate (referencing the AFR in effect), a specific repayment schedule with dates and amounts, and the maturity date. Both the borrower and the trustee sign it. Language like “to be repaid when convenient” invites recharacterization.

Then the payments have to happen. Regular, documented payments of principal and interest on the dates in the note are the single strongest evidence that a real debt exists. Wire transfers or checks build the paper trail. Missed payments, informal deferrals, or balloon structures where nothing moves for years cut the other way.

Collateral isn’t legally required but strengthens the case, because a real commercial lender would take it on a loan of any size. So does documenting, before making the loan, that the borrower has the income or assets to repay. A loan to someone with no realistic ability to pay it back looks like a disguised gift regardless of what the note says.

Forgiving the Loan Doesn’t Clean Things Up

Canceling a trust loan usually creates new tax problems rather than solving old ones. Forgiven debt is generally ordinary income to the borrower.⁸ An exception exists when the cancellation qualifies as a gift, but that just moves the problem: the forgiveness becomes a gift from the lender, and anything above the $19,000 annual exclusion requires a gift tax return.⁶ Forgiving accrued interest year after year is especially risky. It suggests the original transaction was never a real loan, which can retroactively convert the whole principal into a gift or distribution.

Penalties If You Underpay

When a below-market loan causes an underpayment of tax, the IRS can add an accuracy-related penalty of 20% of the underpayment for negligence or a substantial understatement. For a gross valuation misstatement, the penalty doubles to 40%. It doesn’t apply if the taxpayer acted in good faith and had reasonable cause, which is another reason to keep the documentation clean and get professional advice on any loan worth the trouble.

1
Internal Revenue Service. Revenue Ruling 2025-24
2
Office of the Law Revision Counsel. 26 USC 1274 – Section: Determination of Applicable Federal Rate
3
Internal Revenue Service. Applicable Federal Rates
4
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
5
Internal Revenue Service. Revenue Ruling 2025-13 – Section: Table 6
6
Internal Revenue Service. What’s New – Estate and Gift Tax
7
Internal Revenue Service. About Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return
8
Internal Revenue Service. Canceled Debt – Is It Taxable or Not?