Imputed interest is interest that a lender is assumed to have received and must report as income on their taxes regardless of whether they received it. It applies to family loans and other personal and business loans extended at no interest or an interest rate the IRS considers to be too low.
Understand imputed interest to determine when and how it's charged, how much you'll pay as a lender, and how to avoid it.
What Is Imputed Interest?
The Tax Reform Act of 1984 set provisions for “applicable federal rates” (AFRs)—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" and changes them monthly to keep pace with the economy. Moreover, there are different rates for loans of different durations (short-, mid-, and long-term) and compounding periods (annual, semi-annual, quarterly, and monthly).
If the lender extends a "below-market loan," that is, they charge no interest or interest at a rate less than the AFR, the IRS “imputes” or assigns to lenders the interest income they would have received at AFR rates regardless of whether they actually receive it. Lenders, in turn, must enter the interest they are considered to have received—the "imputed interest"—on their tax returns as taxable interest income.
The lenders commonly targeted by this law are parents, family members, and friends—folks who are just trying to help out a loved one in their hour of need. They may extend a loan to someone close to them with the expectation of being repaid eventually, but may not charge interest. The IRS refers to these below-market loans as “gift loans” because the act of not charging interest is considered to be a gift. But it still treats the interest that would have been owed at the applicable imputed interest rate as received by, and taxable to, the lender.
Of course, 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, and the IRS subjects this type of transaction to imputed interest as well.
Most people don’t consider funds 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 and that this is taxable income to the lender.
How Imputed Interest Works
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.
Take a look at an example of imputed interest in action:
- You lend $10,000 to your brother, who lost his job and has a family to support. You expect him to repay you over a three-year period once he gains employment, but since he's family, you don't charge him interest.
- Let's say that the AFR for short-term loans (three years or less) is 1% compounded annually. Since the interest rate you assessed on the gift loan is “below market,” you must apply the AFR to the loan balance and consider the resulting amount as annual interest income.
- You'll report the $100 (0.01*10,000) as interest income on your tax return each year.
Admittedly, 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 (as in the example above where the borrower never paid you any interest). Even if you had charged interest, but at a lower rate than the AFR, you would still pay taxes as if you had charged at the AFR rate since the IRS would impute the difference in interest income to you.
Make gift loans of under $10,000 to avoid being imputed the foregone interest on the loan.
Do I Need to Pay Imputed Interest?
Imputed interest applies not only when no interest is charged, but when a minuscule rate is applied as well—less than that required by the AFR. The same imputed interest rule applies if you don’t actually give cash but rather assign your right to receive income to someone else.
That said, 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. However, the limit doesn’t apply to the gifting of income-producing assets. And 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.
This isn’t a particularly crippling tax law for small loans, and there are at least a few ways you can spare yourself the headache. Going back to the earlier example, give your brother $9,999 rather than $10,000. One buck off removes you from the IRS radar.
You might also consider simply giving the money as a gift rather than a loan if you can afford it. Keep in mind: 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. 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.
- Imputed interest is interest the IRS assumes a lender has received and subjects to taxation whether they have received it or not.
- It applies to below-market loans that impose no interest or inadequate interest.
- Rates change every month and vary based on loan duration and compounding intervals.
- Lenders can avoid imputed interest on below-market “gift loans” for which the foregone interest is treated as a gift by keeping the loan under $10,000.