What Are the Imputed Interest Rate Rules?

When you lend money at a rate lower than the market rate, or at no interest, you have a below-market loan. The Internal Revenue Service (IRS) has regulations for these situations under Internal Revenue Code Section 7872 that create “imputed interest.” This concept treats the loan as if it charged a market-rate interest, even if none was paid.

The purpose of imputed interest is to ensure financial transactions are taxed based on their economic substance. Without these rules, loans could disguise taxable payments, such as an employer providing an interest-free loan to an employee instead of a bonus. The rules prevent this by requiring the lender to recognize the interest income they would have received in a standard lending arrangement.

Transactions Subject to Imputed Interest Rules

The imputed interest rules are targeted at specific relationships where the potential for tax avoidance is high. These regulations primarily cover gift loans, compensation-related loans, and corporation-shareholder loans.

Gift loans typically occur between family members or friends. For example, if a parent lends their child a significant amount of money for a down payment on a house with no interest charged, the IRS may impute interest on that loan. The transaction is viewed as the parent making a loan to the child, and the child making a phantom interest payment back to the parent, which is then treated as a gift.

Compensation-related loans involve an employer providing a loan to an employee at a favorable rate. For example, if a company gives an executive a $100,000 loan at 0.5% interest when market rates are higher, the foregone interest is considered imputed interest. This amount is treated as additional taxable compensation for the employee and a deductible expense for the employer.

A similar logic applies to corporation-shareholder loans. When a corporation lends money to a shareholder at a below-market rate, the imputed interest is treated as a dividend distribution. This amount results in taxable dividend income for the shareholder, but the corporation does not receive a corresponding deduction.

Calculating Imputed Interest Using AFRs

To calculate imputed interest, the IRS uses the Applicable Federal Rates (AFRs), which it publishes monthly. These rates are based on the average market yields of U.S. Treasury obligations and serve as the minimum interest rate for a private loan. If a loan’s stated rate is lower than the relevant AFR, the difference creates imputed interest.

The specific AFR that applies to a loan depends on its duration. The IRS provides three categories for this purpose:

• Short-term rates apply to loans with a term of three years or less.
• Mid-term rates are used for loans over three years but not more than nine years in length.
• Long-term rates are for any loan with a term exceeding nine years.

For example, consider a $50,000 interest-free loan from a father to his son for a five-year term. To determine the imputed interest, one would use the mid-term AFR for the month the loan was made. If the mid-term AFR is 3%, the imputed interest income to the father is $1,500 for that year ($50,000 x 3%), which he must report as income.

The AFR in effect when the loan is initiated must be used. For a term loan, this rate is locked in for the life of the loan, providing certainty for both parties. The lender calculates the “forgone interest,” which is the excess of the interest calculated using the AFR over any interest actually paid.

Tax Consequences and Reporting

Once calculated, imputed interest triggers tax reporting obligations for both the lender and the borrower. The rules create symmetrical tax treatment, where the lender recognizes income and the borrower is treated as having made an interest payment.

For the lender, the imputed interest is taxable income that must be reported on their federal income tax return, on Schedule B (Form 1040). If the loan is related to a trade or business, the lender may also be required to issue a Form 1099-INT to the borrower reporting the imputed interest.

For the borrower, they are treated as having paid the imputed interest back to the lender. This deemed payment may be deductible on the borrower’s tax return, depending on how the loan proceeds were used. For example, if the funds were used for investment purposes, the imputed interest may be deductible as investment interest expense, subject to limitations.

The characterization of the transfer from the lender to the borrower also has tax consequences. In a gift loan, the transfer is a tax-free gift, subject to annual exclusion limits. In a compensation-related loan, it is taxable wages, and for a corporation-shareholder loan, it is a taxable dividend.

Key Exceptions for Below-Market Loans

Specific exceptions exist to relieve common, smaller-scale lending arrangements from these provisions. These de minimis rules are based on the loan size and the borrower’s financial situation.

A common exception is for loans of $10,000 or less. The imputed interest rules do not apply on any day the total outstanding loans between the parties are $10,000 or less. This applies to gift, compensation-related, and corporation-shareholder loans, but not if a gift loan is used to purchase income-producing assets.

Another exception applies to gift loans between individuals of $100,000 or less. Under this rule, the imputed interest the lender must report is limited to the borrower’s net investment income for the year. For example, if the imputed interest is $4,000 but the borrower earned only $500 in net investment income, the lender reports only $500.

Furthermore, this $100,000 exception has its own de minimis threshold. If the borrower’s net investment income for the year is $1,000 or less, it is treated as zero for this rule’s purpose. This means that if a gift loan is $100,000 or less and the borrower has minimal investment income, no interest will be imputed to the lender.