Tuesday, February 21, 2012

Interest-free Gift Loans and § 7872

Interest-free Gift Loans and § 7872 of the Internal Revenue Code

In the case of a “gift loan” –  § 7872(f)(3)  - it defined as a loan bearing a below-market rate of interest when the foregoing of interest is in the nature of a gift – the statute in the IRC creates a deemed interest payment from the borrower to the lender.


  1. The amount of deemed interest payment by the IRS is the difference between interest at the “applicable federal rate” (AFR) and the actual interest charged.
  2. The deemed interest income is taxable to the lender.
  3. The deemed interest payment is deductible by the borrower, subject to the interest expense deductions under § 163.
  4. There is a De minimis exception of § 7872 (c)(2), $10,000 Max
  5. § 7872(d)(1) Deemed interest is limited to the borrowers net investment income for the year.
The whole interest payment is deductible. Interest payment doesn't exceed the loan amount (Only under 100,000).

The Internal Revenue Service will closely examine these transactions under a tax audit, especially if the connection between the parties is a very close. The overall  effect of § 7872 will be to put that lender and the borrower in the same position as if the gift loan had never been made. The deduction qualifies as investment income deduction for lender as well. 

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