When a lender originates a loan with very low interest, the IRS will typically assume the lender has gotten paid with interest. As a result, the IRS will tax the lender as if they have received payment for that interest.

This nonexistent interest is called “imputed interest” and it applies to most loans below the market rate, though some exemptions apply.

Imputed interest often applies to loan agreements made between families and friends, as these are more likely to have very little to no interest. While these transactions are completely legal, the IRS is concerned about loans disguised as gifts[1].

To regulate these circumstances, the IRS imposed a minimum interest rate for loans, known as the Applicable Federal Rate (AFR). When the loan’s interest rate is lower than the AFR, the IRS taxes the loan as if it was using the AFR.

How to Calculate Imputed Interest

It is the lender’s responsibility to declare the imputed AFR when filing for income taxes, regardless of how much they earned in actual interest.

Suppose Person A loans $50,000 to Person B, who intends to use the money to pay off their mortgage. Because they are close friends, Person A decided not to charge any interest and allow Person B to pay off the capital within five years. However, IRS regulations dictate that a minimum of 1.07% in AFR for that month, for example, is required for the transaction.

So, even if Person B pays nothing in interest to Person A, the latter will still have to declare $535 (1.07% of $50,000) as income. That then translates to $535 in taxable income per year until the loan is fully paid off. Again, this cost is charged to Person A, the lender, even if they do not receive any actual interest from Person B.

The lender can calculate their total imputed taxable income with this formula:

Imputed Interest = Capital * AFR * maturity period (in years)

How Does the AFR Work?

The AFR is divided into three categories. They determine the rate table for loans based on their maturity period[2]:

• The short-term rate applies to loans with a maturity period of three years and under.
• The mid-term rate applies to loans with a maturity period of over three years up to nine years.
• The long-term rate applies to loans with a maturity period of over nine years.

The IRS changes the rates every month[3], and lenders should use the APR corresponding to the month the loan was made. The lender would have to declare the imputed interest as income tax until the maturity period ends or until the loan is fully paid.

Imputed interest applies to any type of loan that falls below the average market value. That includes loans between business partners, family members, friends, and businesses and shareholders[4].

Gift Loans

Generally, the IRS is careful about considering low and no-interest loans as a way for two parties to commit tax avoidance—whether intentional or not.

Take the case of a mother who owns a home, its $200,000 mortgage is fully paid off. She transforms it into a rental and earns passive income. She then decides that she wants her son to earn that stream of money instead.

Both parties agree to these terms: the mother sells the home to her son for its mortgage value of $200,000 at zero interest. The son can directly earn from the rental income but has to repay his mother the $200,000 over the next ten years.

While this loan is essentially a gift, there is no way to verify every similar transaction. As a result, the mother would still have to pay imputed interest as prescribed by the IRS.

RELATED: What Is a Non-Arm’s-Length Transaction?

Loans Between Corporations and Shareholders

The IRS recognizes bona fide loans as loans that need to be repaid. The forms these loans could take may involve compensation-related loans, where an employer may owe an employee part of their dues, or a real estate corporation that has lent money to its shareholders.

For a loan to qualify as bona fide, there must be written documentation that:

• An existing loan agreement details the borrower’s intention to repay and the lender’s intention to demand payment.
• The amount of the loan must be reasonable.

The IRS may probe both parties’ intentions. If they do not deem the agreement a bona fide loan, it will be classified as a dividend[5].

Not all loans with interest rates under the AFR will be flagged with imputed interest. A few instances are exempt from the imputed interest rule, such as the following.

1. Gift and Compensation Loans Under $10,000

While gift loans and compensation loans are subject to imputed tax, they are exempt if the value being transferred is under $10,000—as long as the gift was not used to buy income-producing assets. These assets include stocks or capital to start a business.

2. Loans Under $100,000

Typically, housing loans are much larger than $10,000, which is where this second rule comes into play. Say the borrower receives an $80,000 loan and earns $1,000 or more net from an income-producing home (which they purchased with the loan). The lender is then subject to paying for the imputed interest tax.

On the other hand, if the borrower’s net income from the property does not exceed $1,000, then the lender does not have to pay any imputed interest or related tax.

Meanwhile, if the same loan has a small interest rate, and the borrower earns over $1,000 in net income for their rental, the lender would have to pay tax based on the AFR minus the loan interest[6].

Keep in mind that this exemption does not apply if the purpose of lowering or removing interest was due to tax avoidance.

3. Other Loans With No Significant Impact on Tax

The IRS has identified a number of other loans exempt from imputed interest. These include[7]:

• Loans from lenders outside of the United States, as local tax laws do not apply to these transactions.
• Low- or zero-interest loans by lenders due to promotions or traditional business practices (no-interest layaways).
• Student loans and other government-subsidized loans.

 

BY THE NUMBERS: About 19 million Americans have personal loans. On average, each new loan is worth a little over $6,000.

Source: Lending Tree

• Imputed interest applies to loans with below-average or zero interest rates.
• The IRS requires lenders to pay taxes based on their income after the Applicable Federal Rate has been applied to their loan.
• Some exemptions may allow individuals to bypass paying for imputed tax.

1. Denha, R. (n.d.). Low To No Interest Rate Loans To Family – Be Careful. Retrieved from https://denhalaw.com/low-to-no-interest-rate-loans-to-family-be-careful/
2. Evans Estate Law. (n.d.) Applicable Federal Rates for 2021. Retrieved from https://resources.evans-legal.com/?p=2591
3. Internal Revenue Service. (n.d.) Index of Applicable Federal Rates (AFR) Rulings. Retrieved from https://apps.irs.gov/app/picklist/list/federalRates.html
4. ThisMatter.com. (n.d.) Imputed Interest On Below-Market Loans. Retrieved from https://thismatter.com/money/tax/imputed-interest.htm
5. Dana Lee CPA LLC Team. (2017). Taking a Shareholder Loan. Retrieved from http://www.danaleecpa.com/blog/2017/12/18/shareholder-loan/
6. Riley, P. (n.d.). Structure Family Loans. Riley & Associates. Retrieved from http://www.cpa-services.com/special_str.shtml
7. Intuit. (2021.) IRS Tax Rules for Imputed Interest. Retrieved from https://turbotax.intuit.com/tax-tips/tax-payments/irs-tax-rules-for-imputed-interest/L7UbulHpC