Adequate Interest
The IRS uses the applicable federal rate, or AFR, to determine whether a private debt transaction provides for adequate stated interest for various income or transfer[i] tax purposes.
Typically, private debt includes a direct or indirect loan or other transaction that involves an extension of credit between related persons[ii] outside the public markets.
Related Party Loans
Such a transaction may include, for example, (i) a loan of money between family members for any purpose,[iii] (ii) a loan by one family-controlled business to a member of the family[iv] or to a related business, (iii) a loan by an irrevocable family trust[v] to a beneficiary of the trust, or (iv) a sale of property by one family member to another, or to an irrevocable family trust,[vi] in exchange for an installment obligation that is payable over a term of years.
In general, if such a debt has a single fixed rate of interest that is paid or compounded at least annually, and that rate is equal to or greater than the AFR in effect at the time the debt is incurred, then the debt will be treated as having adequate stated interest – i.e., it will not be treated as a below market loan – and certain adverse tax consequences that arise from below market loans will be avoided.[vii]
The AFR
The AFR for a particular month is established by the IRS in the immediately preceding month. It is calculated by reference to the yield to maturity of outstanding marketable obligations of the United States[viii] of similar maturities during the one month period ending on the 14th day of the month preceding the month for which the rates are applicable.[ix]
When a debt is incurred during a particular month, the AFR for the debt is based on its term or maturity; specifically, whether the debt is short-term, mid-term, or long-term.[x]
Market Rate
Thus, in determining the AFR the IRS does not consider any “unique” characteristics of the borrower;[xi] for example, (i) the creditworthiness of the borrower, (ii) whether the loan is guaranteed by a third party with adequate resources, (iii) in the case of a recourse loan, whether the borrower has valuable assets, or (iv) the quality of the collateral if the loan is secured.
Simply put, the creditor’s risks associated with the loan do not enter the AFR calculus; stated differently, the only creditor risk factor taken into account is the term of the loan.
Consequently, the AFR should be lower than the market rate of interest that would be charged by a commercial lender, or any other unrelated creditor for that matter, for a comparable loan to the same borrower.
It is important that related party lenders and borrowers appreciate this economic reality – they need only charge interest at the AFR to be treated as having charged adequate interest for most tax purposes, notwithstanding the AFR is a concededly below market rate.[xii]
Where Are Rates Going?
Although the AFR has been trending downward since January 2025,[xiii] many economists believe that recent economic data points toward a slight increase in the rate of inflation for the rest of 2026 before stabilizing next year.[xiv]
Generally speaking, an increasing interest rate / AFR environment makes loans between related persons relatively less attractive in that the borrower’s investment of the loan proceeds will have to generate a higher return in order to exceed the cost of the loan and yield a net positive economic outcome for the borrower.[xv]
The same concept applies to the sale of property between related persons in exchange for a note[xvi] – will the property acquired appreciate in value at a greater rate than the AFR charged under the note?
Is it Really Debt?
The foregoing discussion assumes that the debtor-creditor relationship between the related persons is respected as such by the IRS.
Unfortunately, that is not always the case. In fact, all too often the related parties to the transaction in question are unable to satisfy the IRS that their economic arrangement represents a bona fide loan.
A recent decision of the U.S. Tax Court[xvii] illustrates certain tax consequences that may arise from such a failure.
Reducing Mom’s Estate
Decedent died at the age of 95. The residue of Decedent’s estate was left to her son (“Taxpayer”), who was also the executor of the estate.
After distributing specific bequests and paying various estate expenses, Taxpayer transferred the remaining assets to himself as the residual beneficiary under Decedent’s will. The estate had no remaining assets after this transfer, so the Probate Court closed the case.
Taxpayer decided not to file an estate tax return.
IRS Exam
Several years later, Taxpayer filed for bankruptcy protection in the U.S. Bankruptcy Court. The IRS learned through the bankruptcy proceedings that Taxpayer had not filed an estate tax return for Decedent’s estate.[xviii]
The agency contacted Taxpayer to initiate an examination regarding the Decedent’s estate tax liability, after which Taxpayer, acting as executor for the estate, filed an estate tax return[xix] on which he reported various assets and claimed various deductions.
Transfer of the Property
Among the assets not reported on the estate tax return was the Property, which Decedent had purchased to use as her personal residence.
About ten years after acquiring the Property, and about seven years prior to her death, Decedent conveyed the Property (via a quitclaim deed) to Taxpayer in exchange for a 30-year, interest-bearing promissory note.[xx] In other words, according to Taxpayer, Decedent “sold” the Property to Taxpayer.
The purpose of the transaction, Taxpayer stated, was to further Decedent’s objective to dispose of all of her assets before her death. After the conveyance, however, Decedent continued to use the property as her personal residence until her death.[xxi]
Converting to a SCIN
A few years after Decedent transferred the Property to Taxpayer, and less than one year before her death, Decedent (who was 95 years old at the time) and Taxpayer amended the promissory note held by Decedent to increase the interest rate, amortize the principal over 30 years,[xxii] and provide for the cancellation of the outstanding balance of the note upon Decedent’s death, thereby removing it from her gross estate (or so they believed or hoped).[xxiii]
It appears that Taxpayer must have agreed to the increase in the interest rate and the acceleration of the loan repayment schedule in exchange for the cancellation-on-death feature.[xxiv]
Taxpayer did not report the transfer of any portion of the Property as a gift for purposes of the gift tax, and he reported the modified note on Decedent’s estate tax return at a value of zero.
True Debt?
During the course of the estate tax exam, the IRS questioned whether the note issued by Taxpayer to Decedent represented a bona fide debt. In other words, the IRS questioned whether the transfer of the Property was a sale as Taxpayer represented.
Taxpayer asserted that he had made regular payments on the note, though he presented no evidence to substantiate that any payments were made; he could not recall the amounts paid or the exact balance of the note at the time of Decedent’s death.
Note’s Value
An IRS expert concluded that the fair market value of the note given by Taxpayer to Decedent in exchange for the Property was much lower than its stated face amount; i.e., it was less than the fair market value of the Property, as determined by Taxpayer and reflected on the face of the note. This conclusion was based on various factors and assumptions, including the presence of the self-canceling provision in the terms of the note, and the assumption that Taxpayer made payments pursuant to the terms of the original note.
The IRS’s expert also concluded that, on the basis of sales of comparable properties, the value of the Property was much greater than the value of the note on the date of the transfer and greater still on the date of Decedent’s death.
Notice of Deficiency
After completing its examination of the estate tax return, the IRS sent Taxpayer, as the estate’s personal representative, a notice of deficiency in which the IRS included the value of the Property in Decedent’s gross estate.
Shortly thereafter, the IRS made a jeopardy assessment against the estate,[xxv] and then notified Taxpayer that he was liable for the estate’s liabilities as a transferee.
Taxpayer petitioned the Tax Court.
Inclusion In Gross Estate
The Court explained that the value of a decedent’s gross estate includes the date of death value of any property that the decedent transferred during their lifetime to another where the decedent retained the right to enjoy the property[xxvi] for the rest the decedent’s life.
The value of transferred property is included in the gross estate even if the decedent makes a lifetime transfer of the property for less than adequate and full consideration and retains an interest or right in the property.
Bona Fide Sale
A transfer of property is not subject to the estate tax if made in a transaction which constituted a bona fide sale for an adequate and full consideration in money or money’s worth.
To constitute a bona fide sale for an adequate and full consideration in money or money’s worth, the transfer must have been made in good faith, and the price must have been an adequate and full equivalent reducible to a money value.
If the price was less than such a consideration, only the excess of the fair market value of the property (as of the applicable valuation date) over the price received by the decedent is included in ascertaining the value of their gross estate.[xxvii]
Court’s Opinion
In the present case, the Court continued, there was no dispute that Decedent made a lifetime transfer of the Property to Taxpayer and continued to retain possession and enjoyment of the Property for the remainder of her life.
The issue, the Court stated, was whether Taxpayer paid adequate and full consideration for the Property.
Taxpayer contended that the Property was transferred to him in a bona fide sale in which he provided a note in exchange for the Property.
In response, the Court stated that the existence of a note or other evidence of a legally enforceable debt was not conclusive evidence of bona fide debt, and it had to be clearly shown that the parties intended to create a debtor-creditor relationship.
Value of the Note
The IRS’s expert testified that the value of the Property around the time of its transfer to Taxpayer was much greater than what the value of Taxpayer’s promissory note would have been if Taxpayer had actually made payments in accordance with the note’s terms.[xxviii]
However, as indicated earlier, Taxpayer presented no evidence other than his own testimony to demonstrate any payment was made toward satisfaction of the debt. In fact, Taxpayer’s testimony demonstrated that he was paying far less than what was required by the terms of the note.
Taxpayer also testified that the purpose of the sale was to make sure Decedent did not hold the Property in her name when she died.
According to the Court, these facts suggested that the parties did not intend to form a true debtor-creditor relationship.
The addition of the self-canceling provision, the Court observed, provided further support for finding that the parties did not intend to form a debtor-creditor relationship. As stated earlier, few months before her death, the note on the Property was amended to add a provision that the note would be canceled, and the remaining debt would be forgiven, upon Decedent’s death.
The Court stated that self-canceling installment notes[xxix] made between family members were presumed to be gifts and not bona fide debt.[xxx]
Furthermore, under the present facts, the parties could not have reasonably expected the debt would ever be paid in full, given that Decedent would have needed to live to the age of 125 for that to happen.[xxxi]
Based on the foregoing, the Court found that Taxpayer and Decedent never intended to create a debtor-creditor relationship and Decedent did not receive adequate and full consideration for the Property.
Accordingly, the Court sustained the IRS’s inclusion of the Property in Decedent’s gross estate at the value determined by the IRS’s expert.
Parting Thoughts
Generally, an individual who lends money at a below-market rate of interest to another individual is treated as making a gift for gift tax purposes and the lender is imputed a commensurate amount of income for income tax purposes.
The Code requires a minimum rate of interest – the AFR – based on the term (duration) of a loan. This rate effectively creates a safe harbor; if the interest rate on a loan is at least equal to the AFR, the loan avoids being a “below-market loan” (the forgone interest on which would have been subject to income tax) and the loan is not treated as a gift for gift tax purposes.
Similarly, a taxpayer will typically sell a valuable asset within their family for a note bearing interest at the AFR to ensure that the loan is not taxed as a below-market loan for income tax purposes. The taxpayer will claim that charging interest at the AFR is sufficient to avoid both the treatment of any foregone interest on the loan as imputed income to the lender and the treatment of any part of the transaction as a gift.
As stated earlier, however, the foregoing assumes the existence of a bona fide debt.
The key to determining the character of a payment between related parties as a loan or as something else ultimately turns on the economic reality of the payment.
If an outside lender would not have extended credit on the same terms and under similar circumstances as did the related person, an inference may arise that the transfer is not a bona fide loan.
On the other hand, if the transfer and surrounding circumstances give rise to a reasonable expectation, and an enforceable obligation, of repayment, then the relationship between the parties will resemble that of a creditor and debtor.
In that case, the form of the transaction should be consistent with, and support, its substance: a genuine loan transaction.
The factors generally identified by the Courts for purposes of determining the nature of a transfer provide helpful guidance for structuring and documenting a loan between related persons. If these factors are considered, the parties to the loan transaction will have objectively determinable proof of their intent, as reflected in the form and economic reality of the transaction. Among these factors are the following:
(1) whether the promise to repay is evidenced by a note or other instrument that indicates indebtedness,
(2) whether adequate interest was charged or paid,
(3) whether a fixed schedule for repayment and a fixed maturity date were established,
(4) whether collateral was given to secure payment,
(5) whether repayments were made,
(6) what the source of any payments was,
(7) whether the borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan, and
(8) whether the parties conducted themselves as if the transaction was a loan.
Of course, the parties will also have to act consistently with what the transaction purports to be – they will have to act as any unrelated party would under the circumstances.[xxxii]
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the firm.
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[i] Basically, estate and gift tax.
[ii] We’ll see shortly why this is the case practically speaking.
[iii] Often, to make an investment, start a business, satisfy a liability, purchase a house, or otherwise provide liquidity to the borrower when needed.
[iv] Who may or may not own equity in the lender. This scenario raises other concerns, including constructive distribution.
[v] For our purposes, references to a “family trust” will mean a trust created by an older member of a family for the benefit of one or more younger members of the family.
[vi] Which may be a grantor trust as to the seller; i.e., a trust of which the seller is the grantor and the assets, income, and liabilities of which are deemed to be owned by the seller. IRC Sec. 671 et seq.
[vii] For example, a cash method lender being required to include accrued interest in gross income before receiving such interest. See, e.g., IRC Sec. 1274 and Sec. 7872.
[viii] A top-tier investment grade rating, which may be manifested in its ability to borrow at a lower interest rate.
[ix] Reg. Sec. 1.1274-4(b). The IRS publishes the AFR for each month as a Revenue Ruling in the Internal Revenue Bulletin. For instance, the IRS issued the AFR for March 2026 in February 2026 as Rev. Rul. 2026-6.
[x] IRC Sec. 1274(d). Short-term: not over 3 years; mid-term: over 3 years but not over 9 years; long-term: over 9 years.
[xi] Indeed, how could it?
[xii] But see the regulations under IRC Sec. 482. The purpose of section 482 is to ensure that taxpayers clearly reflect income attributable to controlled transactions and to prevent the avoidance of taxes with respect to such transactions. The Code authorizes the IRS to use Sec. 482 to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining the true taxable income of the controlled taxpayer and then making appropriate reallocations and other adjustments. Reg. Sec. 1.482-1. A transaction is a controlled transaction for IRC Sec. 482 purposes if the transaction is between two or more organizations, trades, or businesses that are either owned or controlled by the same interests.
Indeed, Reg. Sec. 1.482-2 states that, for purposes of section 482, an arm’s length rate of interest shall be a rate of interest which would have been charged at the time the indebtedness arose in independent transactions with or between unrelated parties under similar circumstances. According to the Reg., all relevant factors are considered, including the principal amount and duration of the loan, the security involved, the credit standing of the borrower, and the interest rate prevailing at the situs of the lender or creditor for comparable loans between unrelated parties.
However, Reg. Sec. 1.482-2 also provides, in the case of a loan or advance between members of a group of controlled entities, that an arm’s length rate of interest shall be not less than 100 percent of the AFR and not greater than 130 percent of the AFR. Reg. Sec. 1.482-2(a)(2)(iii)(B). What the one hand taketh, the other giveth?
[xiii] For reference, the most recently issued CPI-U increased 2.4 percent over the 12 months ending January 2026, after rising 2.7 percent for the year ending December 2025. A year earlier, in January 2025, the 12-month change in the all items index was 3.0 percent. https://www.bls.gov/news.release/cpi.nr0.htm
[xiv] For example, https://www.jpmorgan.com/insights/global-research/economy/global-inflation-forecast
[xv] That said, such a loan may still be sensible; for example, in the case of a related business in need of capital because the AFR will be lower than the cost of a loan for the same amount from an unrelated commercial lender.
[xvi] This includes the sale of property by a member of an older generation to an irrevocable grantor trust for the benefit of a younger family member.
[xvii] Estate of Spenlinhauer v. Comm’r, T.C. Memo. 2025-134.
[xviii] You have to appreciate the fact there are so many ways by which the IRS may become aware of a taxpayer’s “tax history.” I had a matter years ago involving a private foundation that the IRS examined after an article appeared in a newspaper published in New England.
[xix] On Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return.
[xx] Decedent would have been about 88 years old at the time.
[xxi] There was no indication in the opinion that Decedent paid rent to Taxpayer for her continued use of the Property.
[xxii] It’s not clear from the opinion whether the note originally provided for a balloon payment of principal upon the note’s maturity. However, based on statements in the Court’s opinion, it appears the loan’s term was extended to 30 years after the date of the modification. You can’t make this up.
[xxiii] There was no discussion whether these modifications of the terms of the note resulted in an exchange for purposes of the income tax. Reg. Sec. 1.1001-3.
[xxiv] It is not uncommon for a parent-lender to modify the terms of a note issued by a child-borrower where the AFR drops or where the business or investment environment makes it more difficult for the child-borrower to service the loan. In either case, the parent-lender tries to make the debt service easier for the child-borrower. Unfortunately, the parties to the loan often forget that a concession by the parent lender should not be made unilaterally; meaning, that the child-borrower should provide consideration for the loan modification. For example, a reduced interest rate may be paired with an accelerated payment schedule. Any disproportionate exchange of value may be treated by the IRS as a gift, at least in the parent-child setting.
[xxv] See Reg. Sec. 301.6861-1. In general, a jeopardy assessment may be made before or after the notice of deficiency.
[xxvi] IRC Sec. 2036(a). Property is included in the decedent’s gross estate if the decedent retains actual possession or enjoyment of it even if they may not have any enforceable right to do so. A decedent retains possession and enjoyment of the property when there is an express or implied understanding to that effect among the parties at the time of transfer, which may be inferred when intrafamily arrangements are involved.
[xxvii] IRC Sec.; Reg. Sec. 20.2043-1(a).
[xxviii] Remember, where one intends a value-for-value exchange, the value of the note – as distinct from its face amount – must equal the value of the property. For example, the value of a note will be less than that of the property being acquired if the note bears no interest; instead, some portion of the note’s face will be treated as interest and not as consideration for the property.
[xxix] Or “SCINs.”
[xxx] Though the presumption may be rebutted by an affirmative showing that there existed at the time of the transaction a real expectation of repayment and an intent to enforce the collection of the indebtedness.
For example, if the taxpayer was not willing to gift the stock to his family because he required a steady stream of income, he would transfer the stock in exchange for a note that provided for both installment payments of principal plus interest which, had he lived, he would have throughout the term of the note. In other words, there must be a real expectation of repayment, and the intention to enforce the collection of indebtedness. See, e.g., CCA 201330033.
[xxxi] Now, if she had lived in one of the so-called Blue Zones of our planet (not a political affiliation), there may have been some chance.
In the 1970s, Dannon Yogurt aired commercials of elderly residents of what was then Soviet Georgia in which they attributed their longevity to eating yogurt. I suppose she could have moved to the Caucasus.
[xxxii] It is not uncommon for a parent-lender to modify the terms of a note issued by a child-borrower where the AFR drops during the original term of the loan or where the business or investment environment makes it more difficult for the child-borrower to service the loan. In either case, the parent-lender tries to make the debt service easier for the child-borrower. Unfortunately, the parties to the loan often forget that a concession by the parent lender should not be made unilaterally; meaning, that the child-borrower should provide consideration for the loan modification, as would be the case in an arm’s length setting. For example, a reduced interest rate may be paired with an accelerated payment schedule. Any disproportionate exchange of value may be treated by the IRS as a gift, at least in the parent-child setting.
And don’t forget Reg. Sec. 1.1001-3’s debt modification rules.