A handshake loan across the Atlantic is tax-neutral in Britain and a reportable gift in America. How section 7872 recharacterises it, and how to structure one properly.
An interest-free family loan is broadly tax-neutral in the UK but not in the United States. US law treats the forgone interest on a below-market loan as a gift from lender to borrower, and as interest income back to the lender, so one informal favour creates reportable US tax.
It is the most ordinary thing a family does. A parent in Connecticut helps a daughter in London buy a flat; a grandmother in Surrey lends a grandson in Boston the deposit he cannot raise. Nobody wants interest from their own child, so the money goes across with a handshake, or at best a note saying it will be repaid "when she can". In a purely British family that instinct costs nothing. The moment one side of the arrangement is a US person, the same handshake is picked up by a statute written specifically to catch it.
Because the two systems measure different things. UK inheritance tax asks whether value has left your estate. When you lend a relative money, value has not left: cash has been swapped for a debt of the same amount, and that debt is an asset in your estate until it is repaid or released. HMRC's guidance on debts and loans works from exactly that premise, treating a genuine loan as an estate asset rather than a gift (HMRC Inheritance Tax Manual, IHTM28000). Britain has no rule that invents interest you did not charge, and no gift tax to charge it under.
The United States taxes the transfer itself, and takes a less trusting view of what a family loan is. An interest-free loan is economically identical to a gift of the use of money, and families were using it to shift income and value without reporting anything. Section 7872 closes that by deeming two payments to have happened: not a penalty, but a reconstruction of the transaction into the form the IRS considers honest.
A loan is below-market when the interest actually charged is less than the applicable federal rate, a set of rates the IRS publishes monthly in a revenue ruling and which varies by the term of the loan (IRS: Applicable Federal Rates). An interest-free loan is the extreme case: the shortfall is the whole of the market interest.
That shortfall, the forgone interest, is then treated as moving in a circle:
The borrower's side of the circle is usually worthless to them: deemed interest may or may not be deductible depending on how the money was used, and for most family borrowers it produces nothing. The economics are asymmetric by design. The lender is taxed, the borrower is not relieved, and a gift has been made that nobody intended to make.
There is a de minimis carve-out for small gift loans, and a further rule capping the imputed interest on mid-sized gift loans by reference to the borrower's net investment income. Both are fixed statutory dollar ceilings rather than indexed figures, and both are far smaller than the sums families actually move across the Atlantic. Confirm the current ceilings against the statute before relying on either: a loan sized to sit just underneath one of them is a plan that depends entirely on the number being right.
This is the distinction that most often surprises people, and it is the single most important drafting decision in a transatlantic family loan.
A demand loan is repayable whenever the lender asks. Because its term is unknown, section 7872 cannot value the whole arrangement up front, so it is re-tested every year using a blended annual rate. The gift is small and recurring, and in many families each year's deemed gift fits inside the annual exclusion, so nothing has to be reported and no lifetime exclusion is consumed. The cost is uncertainty: the figure moves with rates, and the lender must account for it annually for as long as the loan runs.
A term loan is repayable on a fixed date, so the law can value it, and does so immediately. The entire gift, the present value of all the interest that will never be charged over the whole term, is treated as made in the year the loan is advanced. On a long loan at a meaningful principal that single-year gift can be large enough to require a Form 709 and to bite into the lifetime exclusion in one go (IRS: About Form 709). The interest income, by contrast, is spread across the years of the loan, so the gift and the income do not even land in the same tax years.
Neither structure is automatically better. A demand loan keeps the gift small but never ends; a term loan creates certainty and a large, deliberate, documented gift that may be exactly what the parents wanted. What is never sensible is choosing one by accident, which is what happens when the only piece of paper is a note saying the money will come back one day.
Three things, none of which is imputed interest.
Is it really a loan? If the arrangement is a gift wearing a loan's clothes, with no expectation of repayment and no repayments ever made, HMRC can treat it as what it is. A transfer of value to a relative is a potentially exempt transfer, which falls out of account for inheritance tax only if the donor survives seven years, with relief tapering in the final years before that (gov.uk: Inheritance Tax). The paperwork, and the behaviour that follows it, is what distinguishes the two.
What happens if it is written off? Releasing a debt is a transfer of value in the UK and a gift in the US, in the year of release and for the whole outstanding amount. Families very often start with a loan precisely because a gift felt too big, then waive it later without appreciating that the waiver is the gift they were avoiding.
What happens if the lender dies first? The debt is an asset of the estate, valued at what the borrower owes. For a UK estate that sits against the nil rate band of £325,000 and, where the conditions are met, a residence nil rate band of £175,000 that tapers away by £1 of band for every £2 of estate above £2m. A family loan quietly increases the taxable estate while the borrower enjoys the cash, which is the opposite of what most people assume a loan achieves. If the estate is also within the US net, the same debt is in both computations and the US-UK estate and gift tax treaty decides how relief is allocated.
Charging interest at the applicable federal rate closes the US gift and phantom-income issue. It opens two others. Interest actually received is taxable income to the lender where they are resident, so a UK-resident lender now has UK savings income where before they had nothing. And where a UK-resident borrower pays yearly interest to a lender outside the UK, the borrower can be required to deduct UK income tax at source and account for it to HMRC, with a treaty claim needed to reduce or recover it (HMRC Savings and Investment Manual, SAIM9070). Families almost never do this, because it does not occur to anybody that paying interest to your own mother is a cross-border payment with a withholding obligation attached. It is.
A loan denominated in one currency and repaid to a lender who reports in another is a foreign currency transaction. If a US-person lender advances pounds and is repaid pounds after sterling has moved, the repayment can produce a foreign currency gain that is ordinary income on the US return, separately from anything section 7872 does; the reverse movement does not reliably produce a usable loss. Over a multi-year loan of any size the currency result can exceed the imputed interest, and it is the item most often missed because no statement arrives to prompt it.
Reporting is the adjacent point. The loan receivable itself is not a foreign financial account, but the foreign bank account the money sat in before it moved almost certainly is. A US person whose foreign accounts exceed $10,000 in aggregate at any point in the year files an FBAR, due 15 April with an automatic extension to 15 October (FinCEN Report 114, via the IRS). Opening a sterling account to make a family loan is a common way for an otherwise compliant American to acquire a filing obligation they did not know existed.
The common failure is not aggressive planning. It is a loan made years ago by parents who had no idea section 7872 existed, on which no imputed interest was ever reported and no Form 709 filed, surfacing now because somebody died or sold the flat. The question then is not how to structure it but how to correct it: which years are still open, whether the loan is better documented retrospectively or converted into an acknowledged gift, and what the inheritance tax position is if the lender's estate has been carrying the debt all along.
We take both sides together rather than in sequence, which matters because the US recharacterisation and the UK estate treatment pull in opposite directions and a fix for one can worsen the other. Every position is reviewed and signed off by a licensed professional, an IRS Enrolled Agent who is also an ACCA-qualified accountant, so the US and UK conclusions are reconciled by one reviewer instead of argued between two.
If money is already moving between generations across the Atlantic, our US and UK private client tax service is built for exactly this, and the broader annual position sits with our US-UK tax specialists. You can book a confidential consultation or scope the work before anything is advanced. If a company or trust is being considered instead, read the family investment company for US persons and deeds of variation and US gift tax first: the loan question and the structure question are usually the same question asked twice.