What Is Imputed Interest and How Does It Work?

Imputed interest is an Internal Revenue Service (IRS) concept that creates taxable income from loans with interest rates below what the market dictates. When a loan is made with little or no interest, the IRS can assign, or “impute,” interest to the transaction as if a market rate were charged. This prevents individuals and entities from using these “below-market” loans to avoid taxes or transfer wealth without tax consequences. The government treats the transaction as if the lender charged a fair interest rate, creating income for the lender even if no cash for interest was received.

When Imputed Interest Rules Apply

The imputed interest rules, governed by Internal Revenue Code Section 7872, are triggered by a “below-market loan,” which is any loan with an interest rate below the government’s minimum rate. These rules apply specifically to certain relationships between the lender and the borrower.

One application is for gift loans, which occur between family members or friends. The interest that is forgone by the lender is treated as a gift from the lender to the borrower. If a parent lends a child a significant sum of money interest-free, the IRS views the uncharged interest as a taxable gift each year the loan is outstanding.

Another category is compensation-related loans, made between an employer and an employee or a service recipient and an independent contractor. The forgone interest is treated as additional compensation paid by the employer to the employee. This gives the employer a compensation expense and the employee additional wage income subject to payroll taxes.

The rules also apply to corporation-shareholder loans. When a corporation provides a below-market loan to a shareholder, the forgone interest is characterized as a dividend distribution. The corporation does not get an expense deduction, and the shareholder must report the amount as dividend income, preventing corporations from disguising profits as tax-free loans.

Calculating the Imputed Amount

The basis for calculating imputed interest is the Applicable Federal Rate (AFR), which the IRS publishes monthly. These rates represent the minimum interest that should be charged on a loan to avoid imputed interest. AFRs are based on U.S. Treasury security yields and are separated into three categories based on loan duration: short-term (three years or less), mid-term (over three to nine years), and long-term (over nine years).

The calculation method depends on whether the loan is a term loan or a demand loan. A term loan has a specified repayment schedule and maturity date. For these loans, the calculation is done once when the loan is made, using the AFR in effect on that day. The total amount of forgone interest over the entire term is calculated upfront and allocated over the life of the loan.

A demand loan is payable in full at any time upon the lender’s request and has no fixed term. For these loans, imputed interest is calculated for each calendar year the loan is outstanding. The calculation uses a “blended annual rate” that the IRS releases each year. For instance, if a $50,000 interest-free demand loan is outstanding for a full year when the blended annual rate is 2.5%, the imputed interest is $1,250.

Tax Treatment and Reporting

The IRS treats imputed interest as a two-step transaction. First, the lender is deemed to transfer funds to the borrower as a gift, salary, or dividend, depending on the context. Second, the borrower is deemed to re-transfer that same amount back to the lender as an interest payment.

For the lender, this deemed interest payment must be reported as interest income on Schedule B (Form 1040). If the initial transfer was a gift, the lender may also need to file a federal gift tax return (Form 709). This is required if the forgone interest, combined with other gifts to that person, exceeds the annual gift tax exclusion.

For the borrower, the initial deemed transfer might be taxable income if it was compensation or a dividend, but a gift is not considered taxable income. The deemed interest payment back to the lender may be deductible for the borrower, depending on how the funds were used. For example, if the loan was for investment purposes, the borrower might be able to claim an investment interest expense deduction.

Key Exceptions to the Rules

The tax code provides exceptions that can exempt a loan from imputed interest rules. The most common is the $10,000 de minimis exception. For gift, compensation-related, and corporation-shareholder loans, the rules do not apply as long as the total outstanding loan balance does not exceed $10,000. However, this exception is not available for compensation and corporate loans if a primary purpose of the loan was tax avoidance.

Another exception applies to gift loans of $100,000 or less between individuals. For these loans, the amount of imputed interest the lender must report as income is limited to the borrower’s net investment income for the year. If the borrower’s net investment income is $1,000 or less, the imputed interest is treated as zero.

For example, if a person lends a sibling $80,000 interest-free for a home down payment and the sibling’s net investment income is only $500, no interest is imputed. If the sibling’s net investment income was $5,000, the lender’s imputed interest income would be capped at $5,000, even if the AFR calculation was higher.