Dickman v. Commissioner: Gift Tax on Interest-Free Loans and the AFR

When you lend money to a relative without charging interest, the IRS treats the interest you gave up as a gift to the borrower, and that can trigger gift tax on interest-free family loans above certain thresholds. The rule comes from the Supreme Court’s 1984 decision in Dickman v. Commissioner and the statute Congress passed in response, Internal Revenue Code Section 7872.¹² The clean way to avoid the whole problem is to charge at least the IRS-published minimum rate, called the Applicable Federal Rate, and put the loan in writing.

Why Forgoing Interest Counts as a Gift

In Dickman, the Supreme Court held that the right to use money has real economic value. When a lender hands over capital and asks nothing in return, the borrower gets something worth money and the lender’s estate is depleted by the same amount. That, the Court said, is a transfer of property within the plain language of Section 2501, which taxes any “transfer of property by gift,” and Section 2512, which treats any transfer for less than full consideration as a gift to the extent of the shortfall.³⁴ The Court rejected the argument that demand loans are too uncertain to value: every day the money sits with the borrower, the benefit is real and measurable.¹

Section 7872 turned that principle into a working rule. A loan is “below-market” if it carries an interest rate lower than the Applicable Federal Rate published by the IRS. When it does, the statute imagines two transactions happening at once: the lender is treated as gifting the forgone interest to the borrower, and the borrower is treated as paying that same amount back to the lender as interest. The first piece drives gift tax. The second piece drives income tax, which catches many families by surprise.²

How the Taxable Gift Is Calculated

The math depends on whether you made a demand loan or a term loan.

Demand Loans

A demand loan is one the lender can call back in full at any time. The forgone interest is treated as gifted from lender to borrower on December 31 of each year the loan is outstanding. You apply the short-term AFR to the outstanding principal for the days the loan was active during the year.² If the principal stays fixed for the full calendar year, the IRS lets you use a simplified “blended annual rate” that combines the January and July short-term AFRs, so you don’t have to track monthly changes.

Term Loans

A term loan has a set repayment schedule. The entire gift is calculated once, on the day the loan is made. The gift equals the difference between the principal lent and the present value of all payments due under the loan, discounted at the AFR in effect when the loan started.² For a large, long-term, zero-interest loan, that front-loaded gift can be surprisingly big in year one.

Which AFR to Use

The IRS publishes three AFR tiers each month, keyed to loan duration:⁵

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

Demand loans always use the short-term rate. Term loans use whichever tier matches the stated duration. Because rates change monthly, check the current AFR before you fund the loan.

Loans Small Enough to Ignore the Rule

Congress built in two carve-outs for smaller family lending.

The $10,000 De Minimis Rule

If the total outstanding balance between two individuals stays at or below $10,000, Section 7872 does not apply. No imputed interest, no gift tax, no reporting. The exception disappears if the borrower uses the funds to buy income-producing assets like stocks or rental property.²

The $100,000 Income Tax Cap

For gift loans between individuals where the total outstanding balance stays at or below $100,000, the imputed interest the lender must report as income is capped at the borrower’s net investment income for the year. If the borrower’s net investment income is $1,000 or less, it counts as zero, and neither party owes income tax on the phantom interest.²

Two boundaries on this one. It caps only the income tax side; gift tax still applies to loans between $10,000 and $100,000. And the whole exception vanishes if tax avoidance is one of the principal purposes of the loan, or if the balance climbs above $100,000 on any single day.

The Income Tax Trap

Gift tax gets the attention, but the income tax side is where interest-free lending gets genuinely expensive. Because Section 7872 pretends the borrower paid interest back to the lender, the lender has to report that interest as taxable income even though no cash ever changed hands. Whether the borrower can deduct their side of the fiction depends on how the money was used.²

For demand loans, this happens every year the loan is outstanding. For term loans, the original issue discount rules spread the recognition over the loan’s life. Either way, the lender owes tax on money they never collected.

The Simple Fix: Charge the AFR

A loan that carries interest at or above the AFR is not a below-market loan, so Section 7872 does not apply. No phantom interest, no gift tax calculation, no gift tax return tied to the loan itself. The lender still reports the actual interest they receive as income, but that is a real payment, not a fiction.

To make this work:

Check the AFR for the month you fund the loan and lock the rate in the note.⁵
Match the tier to the term. A five-year loan needs the mid-term rate, not the short-term rate.
Put the terms in a signed promissory note: principal, rate, payment schedule, and maturity date.
Actually collect payments. A note nobody enforces looks like a gift, not a loan.

Even at the AFR, family loans usually beat what a bank would charge, so the borrower still gets a meaningful benefit. The spread between the AFR and market rates is not a gift in the eyes of the tax code.

Documenting the Loan So the IRS Doesn’t Recharacterize It

The worst outcome is not an imputed interest calculation. It is the IRS deciding the “loan” was never a loan and treating the entire principal as a completed gift. Courts look at several factors when deciding whether a family transfer is real debt or a gift wearing a note:

A written, signed promissory note
A fixed maturity date rather than an open-ended arrangement
An interest rate at or above the AFR
An actual record of payments made and deposited
Default provisions the lender could enforce, and ideally collateral
A borrower with the income or assets to repay

No single factor decides the question, but a loan that checks all of them is far harder to recharacterize. Keep the signed note, every payment record, and any correspondence about the terms.

When You Have to File Form 709

If you made a below-market loan and the imputed interest for the year exceeds the annual gift tax exclusion ($19,000 per recipient for 2026), you have to report it on Form 709, the United States Gift and Generation-Skipping Transfer Tax Return.⁶⁷ The return is due April 15 of the year after the gift. An extension of your personal income tax return on Form 4868 automatically extends the gift tax return too.⁸

On Schedule A, list the borrower as the donee and report the imputed interest as the gift’s value. Include the note date, principal, interest rate, and whether the loan is a demand loan or a term loan. That detail usually keeps examiners from asking follow-up questions.

Filing does not automatically mean paying. Gifts above the annual exclusion reduce your lifetime gift and estate tax exemption, which is $15,000,000 for 2026.⁹ Most families making interest-free loans never owe actual gift tax because imputed interest is small next to that number. The filing obligation exists anyway, and skipping it triggers a penalty of 5% of the unpaid tax per month the return is late, up to 25%.¹⁰

Keep copies of every filed return and the rate calculations behind them for at least three years, and longer if the loan is still outstanding.

1
Justia. Dickman v. Commissioner
2
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
3
Office of the Law Revision Counsel. 26 USC 2501 – Imposition of Tax
4
Office of the Law Revision Counsel. 26 USC 2512 – Valuation of Gifts
5
Internal Revenue Service. Applicable Federal Rates
6
Internal Revenue Service. Rev. Proc. 2025-32
7
Internal Revenue Service. Form 709 – United States Gift and Generation-Skipping Transfer Tax Return
8
Internal Revenue Service. Instructions for Form 709
9
Internal Revenue Service. What’s New – Estate and Gift Tax
10
Internal Revenue Service. Failure to File Penalty