896 / Are gifts made of foregone interest or interest-free and bargain rate loans subject to the federal gift tax?

In general, IRC Section 7872 recharacterizes a below-market loan (an interest-free or low-interest loan) as an arm’s length transaction in which the lender (1) made a loan to the borrower in exchange for a note requiring the payment of interest at a statutory rate, and (2) made a gift, distributed a dividend, made a contribution to capital, paid compensation, or made another payment to the borrower which, in turn, is used by the borrower to pay the interest. The difference between the statutory rate of interest and the rate (if any) actually charged by the lender, the “foregone interest,” is thus either a gift to the borrower or income to him, depending on the circumstances. The income tax aspects of below-market loans are discussed in Q 663 and Q 664. The gift tax aspects of such loans are discussed here.

First, some definitions: The term “gift loan” means any below-market loan where the foregoing of interest is in the nature of a gift as defined under Chapter 12. The term “demand loan” means any loan which is payable in full at any time on the demand of the lender. The term “term loan” means any loan which is not a demand loan. The term “applicable federal rate” means: in the case of a demand loan or a term loan of up to three years, the federal short-term rate; in the case of a term loan over three years but not over nine years, the federal mid-term rate; in the case of a term loan over nine years, the federal long-term rate. In the case of a term loan, the applicable rate is compounded semiannually. These rates are reset monthly.¹ The “present value” of any payment is determined as follows: (1) as of the date of the loan; and (2) by using a discount rate equal to the applicable federal rate.² The term “below-market loan” means any loan if in the case of the following: (1) a demand loan, in which interest is payable on the loan at a rate less than the applicable federal rate; or (2) a term loan, in which the amount loaned exceeds the present value of all payments due under the loan. The term “foregone interest” means, with respect to any period during which the loan is outstanding, the excess of the following: (1) the amount of interest that would have been payable on the loan for the period if the interest accrued on the loan at the applicable federal rate and was payable annually on the last day of the appropriate calendar year; over (2) any interest payable on the loan properly allocable to the period.

In the case of a demand gift loan, the foregone interest is treated as transferred from the lender to the borrower and retransferred by the borrower to the lender as interest on the last day of each calendar year the loan is outstanding. In the case of a term gift loan, the lender is treated as having transferred on the date the loan was made, and the borrower is treated as having received on such date, cash in an amount equal to the excess of (1) the amount loaned, over (2) the present value of all payments which are required to be made under the terms of the loan. The provisions do not apply in the case of a gift loan between individuals (two spouses are treated as one person) that at no time exceeds $10,000 in the aggregate amount outstanding on all loans, whether below-market or not. The $10,000 de minimis exception does not apply, however, to loans attributable to acquisition of income-producing assets.