What Is Section 1274(d) of the Internal Revenue Code?
Learn about the IRS rules for imputed interest on debt instruments and how minimum interest rates affect the tax obligations of lenders and borrowers.
The Internal Revenue Service maintains rules to ensure that loans between parties reflect a fair market interest rate for tax purposes. This framework is designed to prevent the use of artificially low interest rates to recharacterize payments and avoid taxes. When a private loan is made with an interest rate below what the market demands, the IRS is empowered to step in.
In these situations, tax law requires the calculation of a minimum amount of interest income for the lender, even if that interest was not actually paid by the borrower. This concept, known as imputed interest, restates the transaction to align with economic reality. It ensures that a loan is treated as a loan for tax purposes, and not as a disguised gift or capital contribution.
Understanding the Applicable Federal Rates
The mechanism the IRS uses to enforce minimum interest is the Applicable Federal Rate, or AFR. These rates are established under Internal Revenue Code Section 1274(d) and represent the minimum interest rates that should be charged on most private loans. The purpose of the AFR is to prevent tax avoidance, such as a seller agreeing to a low interest rate on a loan in exchange for a higher, tax-favored capital gain purchase price.
The AFR system is divided into three categories determined by the term of the debt. For loans with a term of three years or less, the short-term AFR applies. If a loan has a term of more than three years but not more than nine years, the mid-term AFR is used. For any debt with a term exceeding nine years, the long-term AFR is the correct measure. This segmentation ensures the rate reflects the risks associated with varying loan durations.
These rates are derived from the average market yields on outstanding U.S. government obligations, such as Treasury bills and bonds, with similar maturities. By tying the AFR to the yields on federal debt, the IRS ensures the rates are a reasonable proxy for a risk-free return in the open market.
Locating the Current Applicable Federal Rates
The IRS updates the Applicable Federal Rates monthly to reflect current market conditions and publishes them in documents called Revenue Rulings. Each month, the IRS issues a new Revenue Ruling that lists the AFRs for the following month, giving taxpayers advance notice of the rates for upcoming transactions.
To find the current rates, search for “Applicable Federal Rates Revenue Ruling” on the IRS website. This search leads to a page that lists these rulings in reverse chronological order. The ruling document contains several tables of interest rates.
Within the Revenue Ruling, there are multiple tables because interest can be compounded over different periods. The terms of the specific loan agreement dictate which compounding table is appropriate. For example, if a loan agreement specifies that interest is calculated annually, the annual compounding table would be used. The document will present separate AFRs for:
- Annual compounding
- Semiannual compounding
- Quarterly compounding
- Monthly compounding
Applying the Rates to a Debt Instrument
Once the correct AFR has been identified, it is used to test the sufficiency of the interest rate stated in a debt instrument. This test involves a direct comparison: if the interest rate in the loan agreement is equal to or greater than the relevant AFR, the loan has “adequate stated interest.” In this case, the IRS accepts the loan as structured, and the stated interest is what the lender reports as income and the borrower may deduct.
If the loan’s stated interest rate is lower than the applicable AFR, the transaction fails the test. This triggers the rules for Original Issue Discount, or OID. OID is a form of interest that is not explicitly paid but is created when a debt instrument is issued for a price less than its redemption value. The IRS then recalculates the loan’s principal amount by discounting all future payments back to the present using the AFR, which must be compounded semiannually for this calculation. The difference between this new, lower “imputed principal amount” and the actual stated principal is the OID.
The tax consequences of OID are significant for both parties. The lender must recognize and include the OID in their gross income over the life of the loan, even though they are not receiving cash payments for this “phantom” interest. This means the lender pays taxes on income they have not yet received. Conversely, the borrower can deduct the same amount of OID as interest expense over the loan’s term.
Consider a seller who finances the sale of a commercial property for $1 million, carrying a note for the full amount due in ten years with no interest payments. If the long-term AFR is 5%, the IRS will not accept the 0% interest rate. To determine the loan’s value for tax purposes, the $1 million payment is discounted back ten years. This calculation must use the 5% AFR compounded semiannually, resulting in an imputed principal amount of $610,270.94. The OID is the difference: $1,000,000 minus $610,270.94, which equals $389,729.06. The seller must gradually report this $389,729.06 as interest income over the ten-year term, and the buyer can deduct it over the same period.