663 / What is a below-market loan?

Generally, a below-market loan is any demand loan with an interest rate that is below the applicable federal rate (see below) or any term loan in which the amount received by the borrower exceeds the present value of all payments due under the loan. A demand loan is any loan that is payable in full at any time on the demand of the lender, or that has an indefinite maturity. All other loans are generally term loans.¹ IRC Section 7872 essentially recasts a below-market loan into two phantom transactions (meaning they are deemed to have occurred, even though they did not actually occur): (1) an arm’s-length loan pursuant to which the borrower paid (but obviously did not) interest to the lender at the applicable federal rate, and (2) a deemed transfer of interest to the lender that the borrower should have, but did not, pay to the lender (“imputed transfer”).²

In other words, in (1) above, it is as if the lender transferred to the borrower the amount of interest at the applicable federal rate the borrower should have paid the lender less the amount of interest, if any, that the borrower actually did pay to the lender; and, subsequently in (2) above, the borrower is treated as paying the amount of foregone interest to the lender as interest. Generally, the lender must report the imputed transfer of the foregone interest as interest income. Conversely, depending on the relationship of the borrower to the lender, the borrower may or may not be required to include the foregone interest in income (for example if the loan was between family members the foregone interest that is deemed to have been received may be treated as an income tax-free gift). Additionally, depending on the nature of the borrowing, the borrower may or may not be entitled to an interest deduction (i.e., used the borrowed funds for a vacation).

Example: On January 1, 2023, Samuel loans Asher $100,000 (interest free) payable on demand. As of December 31, 2023, the loan remains outstanding. Obviously, because the loan bears no interest, it is a below-market loan. Since the 2023 blended annual rate is 4.65 percent (see below), IRC Section 7872 would recast the below-market loan into the following two transactions:

1) For tax year 2023, Samuel is deemed to have transferred $4,650 of foregone interest to Asher, the amount Asher should have paid Samuel (even though this not actually occur).

2) In turn, Asher is deemed to have paid the $4,650 of foregone interest to Samuel (even though Asher did not make the payment).