Imputed interest is a tax concept used by the Internal Revenue Service (IRS) to address loans that have no stated interest rate or an interest rate lower than the Applicable Federal Rate (AFR). The AFR is a minimum interest rate set monthly by the IRS based on market yields. When a loan’s interest rate is below this rate or absent altogether, the IRS assumes or “imputes” an interest amount as if the borrower paid the minimum federal rate. This imputed interest is considered taxable income to the lender and may affect both the lender’s and borrower’s tax obligations.
Why Does the IRS Impose Imputed Interest?
The IRS uses imputed interest to prevent taxpayers from avoiding taxes by disguising what really are interest payments as gifts or non-interest-bearing loans. Without imputed interest rules, a lender could lend money to a family member or friend interest-free, avoiding declaring interest income, which would reduce the taxable income reported.
Applicable Federal Rates (AFRs)
The AFR is the benchmark that the IRS uses to calculate imputed interest. These rates are updated monthly and depend on the term of the loan:
- Short-term AFR: For loans with terms up to 3 years.
- Mid-term AFR: For loans with terms between 3 and 9 years.
- Long-term AFR: For loans longer than 9 years.
If a loan’s stated interest is below the AFR for its term, the IRS imputes interest at the AFR.
Types of Loans Typically Affected
Imputed interest rules often apply to:
- Family loans with little or no interest stated.
- Below-market loans between related parties or businesses.
- Certain demand loans.
Tax Reporting and Implications
Lenders must report imputed interest as taxable income on their federal income tax returns, typically using Form 1040 Schedule B or the appropriate form for businesses. Borrowers cannot deduct imputed interest.
Example
Suppose you lend $10,000 to a relative interest-free for five years. The mid-term AFR is 3%. The IRS will treat you as having received $300 in interest income annually ($10,000 x 3%), even if you do not actually receive these payments. You must report this imputed interest income on your tax return.
Additional Resources
For more details on imputed interest and the related tax rules, see IRS Publication 550 on investment income and IRS Publication 9465 on payment plans (https://www.irs.gov/publications/p550).
Understanding imputed interest ensures compliance with IRS regulations and helps prevent unexpected tax liabilities on interest income that taxpayers might overlook.