What Is the Section 7872(e)(2) Blended Annual Rate?

Internal Revenue Code Section 7872 provides rules for loans with interest rates below the market standard. When a loan is provided at a low or zero interest rate, the Internal Revenue Service (IRS) may treat the arrangement as if a market rate of interest was charged. This is known as “imputed interest,” where the lender is considered to have received interest income, and the borrower is considered to have paid it.

The tax code establishes frameworks for calculating this imputed interest, which can vary based on the type of loan. These rules prevent using below-market loans to avoid taxes on transactions that are effectively gifts, dividends, or compensation for services.

Defining the Blended Annual Rate

The blended annual rate is an interest rate the IRS publishes to simplify calculations for certain loans. Released annually, this rate is for a demand loan that has been outstanding for the entire calendar year. A demand loan is payable in full at any time upon the lender’s request and is common for informal loans between family members or a corporation and its shareholders.

This rate differs from the Applicable Federal Rates (AFRs), which the IRS publishes monthly for term loans and demand loans not outstanding for the full year. The blended annual rate is an average of the short-term AFRs, providing a single rate for the whole year’s calculation on qualifying demand loans.

For reference, the IRS has published the following blended annual rates in recent years:

• 2024: 5.03%
• 2023: 4.65%
• 2022: 1.40%

This single rate allows taxpayers to determine the amount of “foregone interest,” which is the difference between the interest that should have been charged using the AFR and the interest that was actually charged.

Calculating Foregone Interest Using the Blended Annual Rate

This calculation applies only to demand loans with a fixed principal amount that were outstanding for the entire calendar year. If the loan was not outstanding for the full 12 months or the principal changed, the monthly Applicable Federal Rates must be used instead.

To calculate the foregone interest, the loan’s principal is multiplied by the blended annual rate for that year. For example, consider a $50,000 interest-free demand loan from a parent to a child that was outstanding for all of 2024. The blended annual rate for 2024 was 5.03%.

The calculation would be $50,000 multiplied by 5.03%, which equals $2,515. The final step is to subtract any interest that the borrower actually paid during the year. If no interest was paid, the total foregone interest is $2,515. If the child had paid $500 in interest, the foregone interest would be reduced to $2,015 ($2,515 – $500).

Tax Reporting for Imputed Interest

Once the foregone interest is calculated, both the lender and the borrower have reporting responsibilities. The lender must report the foregone interest amount as interest income on their tax return, for instance, on Schedule B of Form 1040. If the loan is between a business and an individual, the lender may be required to file Form 1099-INT if the imputed interest is $10 or more.

From the borrower’s perspective, the foregone interest is treated as an interest expense. The borrower may be able to deduct this amount, subject to the standard rules for interest deductions. For example, if the loan was used for investment purposes, the imputed interest may be deductible as investment interest expense. The borrower should attach a statement to their tax return detailing the calculation if they claim a deduction.

The character of the initial imputed transfer from the lender to the borrower depends on their relationship. For a loan between family members, it is considered a gift. If the loan is from an employer to an employee, it is treated as compensation, and if from a corporation to a shareholder, it is a dividend.

Key Exceptions to the Below-Market Loan Rules

The tax code provides specific exceptions that exempt certain loans from the imputed interest rules. These de minimis rules are based on the loan amount and its purpose, relieving taxpayers from tracking imputed interest on smaller loans.

One of the most common exceptions applies to gift loans between individuals. If the total outstanding loan balance between the lender and borrower is $10,000 or less, the below-market loan rules do not apply. This rule does not apply if the loan is used to purchase or carry income-producing assets.

A separate $10,000 de minimis exception exists for compensation-related and corporation-shareholder loans. If the aggregate outstanding loans between the parties do not exceed $10,000, the imputed interest rules are waived. This exception is not available if a principal purpose of the interest arrangement is the avoidance of any federal tax.