Definition and Example of Imputed Interest
The Tax Reform Act set provisions for applicable federal rates (AFRs) in 1984. This is a minimum interest rate that must be charged on all loans, even personal loans. The IRS publishes the rates online as an Index of AFR Rulings. It changes them monthly to keep pace with the economy.
There are different rates for loans of different durations (short-, mid-, and long-term) and with different compounding periods, such as annual, semiannual, quarterly, or monthly.
The IRS “imputes” or assigns to lenders the interest income they would have received at AFR rates if they extend a below-market loan. They charge no interest or interest at a rate that's less than the AFR, regardless of whether they actually receive the money. Lenders must enter the "imputed interest," the interest they're considered to have received, on their tax returns as taxable income.
Most people don’t consider money they lend to family or friends to be official transactions, but the IRS takes the position that all loans should pay at least a minimal amount of interest.
The IRS imputes interest income to taxpayers who make loans to ensure that the federal government gets its fair share of all financial transactions, including exchanges of money between family and friends.
An Example of Imputed Interest
Suppose your sibling has lost their job, and they have a family to support. You lend them $10,000 to help make ends meet. You expect them to repay you over a three-year period when they start a new job, but you don’t charge them interest, because you just want to help out.
The AFR for short-term loans of three years or less is 1% at the time, compounded annually. The interest rate you assessed on the gift loan is “below market," because you're not charging any interest at all. You must therefore apply the AFR to the loan balance. The resulting amount is annual interest income. You must report the $100 (0.01 x 10,000) as interest income on your tax return each year.
Imputed interest on a small loan isn’t enough to break the bank when you pay your marginal tax rate on it, but you must report and pay taxes on it, even if you never received it. You would still pay taxes as if you had charged at the AFR rate or if you had charged interest at a lower rate than the AFR. The IRS would impute the difference in interest income to you in that case.
How Imputed Interest Works
Lenders who are most commonly targeted by this law are parents, family members, and friends. They're folks who are just trying to help out in someone's hour of need. The IRS refers to these below-market loans as “gift loans.” Charging zero interest is considered to be a gift, but the IRS still treats the interest that would have been owed at the applicable imputed interest rate as though it had been received. Thus, it's taxable to the lender.
The imputed interest rule extends beyond loans to family members and friends. A business might front an employee or owner money at no interest under difficult circumstances, for example. The IRS subjects this type of transaction to imputed interest as well.
Do I Need to Pay Tax on Imputed Interest?
Imputed interest applies when no interest is charged or when a minuscule rate, less than that required by the AFR, is applied. The same imputed interest rule applies if you don’t actually give cash but assign your right to receive income to someone else.
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 last cent of income that changes hands. The tax code exempts gift loans of under $10,000 from the imputed interest rule. The same threshold of $10,000 goes for employment-related loans and those made to shareholders.
Alternatives to Earning Imputed Interest
This isn’t a particularly crippling tax law for small loans. There are at least a few ways you can spare yourself the headache. You can give your sibling $9,999 rather than $10,000. One buck off removes you from the IRS radar.
The limit doesn’t apply to the gifting of income-producing assets. The total amount of imputed interest can’t exceed the borrower’s net investment income in the case of loans of $100,000 or less.
You might also consider simply giving the money as a gift, rather than as a loan, if you can afford it. The IRS also imposes a gift tax that's payable by the donor, but the annual cap is $16,000 per person in 2022, up from $15,000 in 2021.
This threshold is referred to as an "annual exclusion from the gift tax." You can give your sibling $10,000 tax-free, because it’s under the exclusion, as long as you don’t want the money back.
- Imputed interest is interest the IRS assumes a lender has received. It's subject to taxation regardless of whether the lender has actually received it.
- The rule applies to below-market loans that impose no interest or too little interest.
- Rates change every month. They vary based on loan duration and compounding intervals.
- Lenders can avoid imputed interest on below-market “gift loans” by keeping loans under $10,000.