26 U.S.C. § 7872 — Treatment of loans with below-market interest rates

(a) Treatment of gift loans and demand loans.
(1) In general. For a below-market loan this section covers that is a gift loan or a demand loan, the interest the lender gave up ("forgone interest") is treated as (A) transferred from the lender to the borrower, and then (B) transferred right back from the borrower to the lender as interest paid.
(2) Time when transfers made. Unless regulations say otherwise, forgone interest for any period during a calendar year is treated as transferred (and transferred back) on the last day of that year.

(b) Treatment of other below-market loans.
(1) In general. For a below-market loan this section covers that is not a gift or demand loan, the lender is treated as having handed the borrower cash on the date the loan was made, equal to (A) the amount loaned, minus (B) the present value of the payments the loan actually requires.
(2) Obligation treated as having original issue discount. (A) That loan is treated as having "original issue discount" (OID) equal to the amount described in (1). (B) This OID is added on top of any other OID the loan already has.

(c) Below-market loans to which this section applies.
(1) In general. Except as this subsection and subsection (g) say, this section covers: (A) Gifts — any gift loan. (B) Compensation-related loans — loans between an employer and employee^*, or between an independent contractor and someone they work for. (C) Corporation^*-shareholder^* loans — loans between a corporation and its shareholders^*. (D) Tax avoidance loans — any loan where a main reason for its interest terms is dodging federal tax. (E) Other below-market loans — as regulations may specify, any other loan not covered above whose interest terms have a real effect on someone's federal tax bill. (F) Loans to qualified continuing care facilities made under a continuing care contract.
(2) $10,000 de minimis exception for gift loans between individuals. (A) This section does not apply, on any day, to a gift loan directly between individuals if the total outstanding loans between them are $10,000 or less. (B) This exception does not apply to a gift loan used to buy or hold income-producing property. (C) See subsection (d)(1) for a related limit where loans stay under $100,000.
(3) $10,000 de minimis exception for compensation-related and corporate-shareholder loans. (A) This section does not apply, on any day, to a compensation-related or corporation-shareholder loan if the total outstanding loans between borrower and lender are $10,000 or less. (B) This exception does not apply if a main purpose of the loan's interest terms is dodging federal tax.

(d) Special rules for gift loans.
(1) Limitation on interest accrual for income tax purposes where loans stay under $100,000. (A) For a gift loan directly between individuals, the amount treated as paid back as interest each year cannot exceed the borrower's net investment income for that year. (B) This limit does not apply if a main purpose of the loan is tax avoidance. (C) If a borrower has more than one gift loan outstanding, their net investment income is divided among the loans in proportion to what each would otherwise generate. (D) This limit does not apply at all once the total loans between borrower and lender exceed $100,000. (E) "Net investment income": (i) has the meaning given in section 163(d)(4); (ii) is treated as zero if it's $1,000 or less for the year; (iii) also includes, for this purpose, amounts that would count as income under section 1272 if that rule applied to all deferred payment obligations; (iv) "deferred payment obligation" includes market discount bonds, short-term obligations, U.S. savings bonds, annuities, and similar obligations.
(2) Special rule for gift tax. For a gift loan that is a term loan, subsection (b)(1) — not subsection (a) — applies for gift-tax purposes.

(e) Definitions of below-market loan and forgone interest.
(1) Below-market loan. A loan is "below-market" if (A) for a demand loan, its interest rate is below the applicable federal rate (AFR), or (B) for a term loan, the amount loaned is more than the present value of the required payments.
(2) Forgone interest. For any period the loan is outstanding, this is the excess of (A) the interest that would have been due if the loan carried interest at the AFR, paid annually, over (B) the interest actually due and properly counted for that period.

(f) Other definitions and special rules.
(1) Present value. Determined under Secretary^* regulations, as of the loan date, using the AFR as the discount rate.
(2) Applicable Federal rate (AFR). (A) For term loans, the AFR in effect under section 1274(d) on the day the loan was made, compounded twice a year. (B) For demand loans, the federal short-term rate under section 1274(d) for the relevant period, compounded twice a year.
(3) Gift loan. A below-market loan where giving up the interest is meant as a gift.
(4) Amount loaned. The amount the borrower actually received.
(5) Demand loan. A loan payable in full whenever the lender demands it. It also includes (except when figuring the AFR) a loan whose interest benefits can't be transferred and depend on an individual doing more work in the future, and — where regulations say so — a loan with no fixed maturity date.
(6) Term loan. Any loan that is not a demand loan.
(7) Husband and wife are treated as one person.
(8) Loans covered by section 483, 643(i), or 1274 are not covered by this section.
(9) No withholding. No tax is withheld under chapter 24 on amounts treated as transferred under (a) or received under (b).
(10) Special rule for term loans. Once this section starts applying to a term loan, it keeps applying despite the de minimis exceptions in (c)(2) and (c)(3) — though for a gift loan, that continued coverage is only for gift-tax purposes.
(11) Time for determining rate applicable to employee relocation loans. (A) For a term loan an employer makes to an employee to buy a main home, the AFR is set as of the date the written purchase contract was signed. (B) This only applies where the move qualifies under section 217 (moving expenses), for a new job or a change in work location.

(g) Exception for certain loans to qualified continuing care facilities. (1) In general. This section does not apply, for a calendar year, to a below-market loan a lender makes to a qualified continuing care facility under a continuing care contract, if the lender (or the lender's spouse) turns 65 before the end of that year. (2) $90,000 limit. This exception applies only up to $90,000 in total outstanding loans between that lender (or spouse) and any qualified continuing care facility. (3) "Continuing care contract" means a written contract where (A) the individual or spouse may use the facility for life; (B) the individual or spouse will first live in a separate independent unit (with outside help for meals and personal care) without needing long-term nursing care, and later receive long-term and skilled nursing care as their health requires; and (C) no extra substantial payment is required if they later need more care. (4) "Qualified continuing care facility" means (A) one or more facilities designed to provide continuing-care-contract services, where substantially all residents have such contracts; (B) with substantially all of the required facilities owned or run by the borrower; excluding (C) anything that is really a traditional nursing home. (5) The $90,000 limit is adjusted upward each year for inflation, rounded to the nearest $100. (6) This exception does not apply for any year covered instead by subsection (h).

(h) Exception for loans to qualified continuing care facilities (age-62 version). (1) In general. This section does not apply, for a calendar year, to a below-market loan owed by a facility that is, on the last day of that year, a qualified continuing care facility, if the loan was made under a continuing care contract and the lender (or spouse) turns 62 before the end of the year. (2) "Continuing care contract" means a written contract where (A) the individual or spouse may use the facility for life; (B) they will be housed as their health requires, first in an independent living unit (with outside help for meals and care) and later in assisted living or nursing care as available; and (C) they will get assisted living or nursing care as their health requires and as the facility has available. The Secretary must issue guidance limiting this term to contracts providing only what is described here. (3) "Qualified continuing care facility" means (A) one or more facilities designed to provide continuing-care-contract services, that include an independent living unit plus assisted living or nursing care (or both), where substantially all independent-living residents have such contracts; excluding (B) anything that is really a traditional nursing home.

(i) Regulations. (1) The Secretary must issue regulations needed to carry out this section, including rules that (A) adjust how the section applies when varying interest rates, conditional payments, waived interest, or transfers of the loan mean the section isn't working as intended; (B) make sure the borrower and lender are treated consistently; and (C) exempt classes of loans whose interest terms don't meaningfully affect anyone's federal tax bill. (2) Estate tax coordination. Under Secretary regulations, a term loan made with the intent to give a gift is factored into estate tax (chapter 11) in a way consistent with subsection (b).