What Is Imputed Interest?
The IRS Expects You to Charge Interest on Loans
The IRS imputes interest income to taxpayers who make loans to ensure that the federal government is getting its fair share of all financial transactions, including exchanges of money between family and friends. Most people don’t consider these to be “transactions,” but the IRS takes the position that all loans should pay at least a minimal amount of interest, and this would be taxable income to the lender.
The Definition of Imputed Interest
The Tax Act of 1984 set provisions for “applicable federal rates” (AFRs)—a minimum interest rate that must be charged on all loans, even personal ones. The IRS will “impute” or assign this interest income to lenders regardless of whether they actually receive the money. It must be entered on tax returns as taxable income regardless.
The lenders targeted by this law are often parents, family members, and friends—folks who are just trying to help out a loved one in their hour of need. They expect to be repaid…eventually. And the IRS expects that repayment to include interest. The IRS refers to these transactions as “gift loans” because the act of not charging interest is considered to be a gift.
Imputed interest applies not only when no interest is charged, but when a minuscule rate is applied as well; less than required federal thresholds.
The Applicable Federal Rate
The IRS expects you to charge the applicable federal interest rate when you make a loan, and the feds change this rate monthly so it keeps pace with the economy. There’s actually more than one rate. They’re divided into categories for short-, mid-, and long-term loans, and into compounding periods.
Even if you don’t charge this much, you’ll pay taxes on it regardless.
When Enough Interest Isn’t Charged: An Example
Maybe your brother has lost his job. He has three kids to support, and his spouse doesn’t work. You’re doing pretty well these days so you give him $10,000 to help out, with the understanding that he’ll begin returning a few hundred dollars a month to you when he begins working again. Maybe he’s a little irresponsible with money, so you tack on 1% interest to make him understand that you mean business.
But the applicable federal rate is 2% at the time the loan is made, so your loan is 1% “below market.” A 2% interest rate works out to $200—admittedly not enough to break the bank when you have to pay your marginal tax rate on it. You must report that $200 as “other income” on your tax return even if your brother only pays you the 1% or $100…or if he never pays any interest at all.
Let’s say that you made the loan to your brother in February 2020. The applicable annual federal rate was 1.59% at that time for short-term loans, going up to 1.75% for a mid-term loan, and to 2.15% for a long-term loan. You must apply the applicable rate to the loan balance and report the whole amount as other income on your tax return.
It’s Not Just a Family/Friend Issue
Of course, all this extends beyond family members and friends. A company might front an employee some pay under difficult circumstances, and the IRS considers this type of action to be a loan as well. The same goes for money changing hands between S corporations and their shareholders.
The same imputed interest rule applies if you don’t actually give cash but rather assign your right to receive income to someone else. You have to charge interest based on the applicable federal rate at the time the assignment was made.
If the recipient of your loaned money invests it, now you—not the recipient—must also pay tax on the interest that the investment earned.
Some Important Exceptions
Don’t start worrying over that $500 you contributed to your daughter’s rent last month. The IRS really isn’t interested in keeping track of every half-cent of income that changes hands. The tax code exempts gift loans of under $10,000 from the imputed interest rule. The same threshold—$10,000—goes for employment-related loans and those made to shareholders. However, the limit doesn’t apply to the gifting of income-producing assets, however.
In the case of loans of $100,000 or less, the total amount of imputed interest can’t exceed the borrower’s net investment income.
What to Do?
This isn’t a particularly crippling tax law for small loans, and there are at least a couple of ways you can spare yourself the headache. First, in the case of your brother, give him $9,999 rather than $10,000. A hundred pennies off removes you from the IRS radar.
You might also consider simply giving the money as a gift if you can afford it and if it’s a smaller loan. The IRS imposes a gift tax, too, and it’s also payable by the donor, but the cap is $15,000 per person per year as of 2020. This threshold is referred to as an annual exclusion from the gift tax. So you can give your brother $10,000 tax-free because it’s under the exclusion…as long as you don’t want the money back.
The Joint Committee on Taxation. "PROVISIONS OF THE TAX REFORM ACT OF 1984 AFFECTING THE FEDERAL TAX TREATMENT OF INTEREST ON DEFERRED PAYMENT SALES OF PROPERTY." Page 10-12. Accessed March 4, 2020.
IRS. “Index of Applicable Federal Rate (AFR) Rulings.” Accessed March 4, 2020.
U.S. Small Business Administration. "5 Tax Rules for Deducting Interest Payments." Accessed March 4, 2020.
IRS. “Section 1274—Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property.” Page 2. Accessed March 4, 2020.
Michigan Society of Enrolled Agents. “Imputed Interest.” Pages, 2, 3, 6. Accessed March 4, 2020.
Cornell Law School. "26 U.S. Code § 7872. Treatment of Loans with Below-Market Interest Rates." Accessed March 4, 2020.