What Is Imputed Interest?

The imputed interest is the interest that a creditor is presumed to have received and must report as income on his taxes, regardless of whether he has received them. It applies to family and other personal and business loans without interest or at an interest rate that the IRS considers very low.

Understand the interest charged to determine when and how it is charged, how much you will pay as a creditor, and how to avoid it.

What is the imputed interest?

The Tax Reform Act of 1984 established provisions for applicable federal rates (AFRs), a minimum interest rate that must be charged on all loans, including personal loans. The IRS publishes rates online as an index of AFR decisions and changes them monthly to keep them. pace with the economy. In addition, there are different rates for loans of different duration (short, medium and long term) and compound periods (annual, semi-annual, quarterly and monthly).

If the lender extends a loan below the market, that is, does not charge interest or interest at a rate below the AFR, the IRS "imputes" or attributes to the lenders the interest income that they would have received at the AFR rates, regardless of whether they actually receive it. Creditors, in turn, must record the interest they are deemed to have received - the "imputed interest" - on their tax returns as taxable interest income.

The creditors generally targeted by this law are parents, family and friends, people who are only trying to help a loved one in a time of need. They may make a loan to someone close to them with the expectation of eventually paying it back, but they may not charge interest. The IRS refers to these below-market loans as "gift loans" because the act of not charging interest is considered a gift. But the IRS still treats interest that would be owed at the applicable imputed interest rate as received and taxable to the creditor.

Obviously, the charged interest rule extends beyond loans to family and friends. A business can give money without interest to an employee or owner in difficult circumstances, and the IRS also subjects this type of transaction to imputed interest.

How Imputed Interest Works

The IRS imputes interest income to taxpayers who apply for loans to ensure that the federal government receives its fair share of all financial transactions, including exchanges of money between family and friends.

Take a look at an example of imputed interest on the stock:

You loan $ 10,000 to your brother, who has lost his job and has a family to support. You expect me to pay you back within three years, once I get a job, but since it's a family, you don't charge interest.
Let's say the AFR for short-term loans (three years or less) is made up of 1% per year. Since the interest rate you assessed on the gift loan is "below market," you should apply the AFR to the loan balance and consider the resulting amount as annual interest income.
You will need to report $ 100 (0.01 x 10,000) as interest income on your income tax return each year.

It is true that the interest charged on a small loan is not enough to ruin 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 them (as in the example above, where the borrower has never paid interest).

Even if you had charged interest, but at a lower rate than the AFR, you would still pay taxes as if you had collected the AFR rate, because the IRS would charge you the difference in interest income.

Do I Need to Pay Imputed Interest?

The interest charged is applied when no interest is charged and when a small rate is applied, lower than that required by the AFR. The same imputed interest rule applies if you don't give money, but instead assign your right to receive income to someone else.

With that said, don't start worrying about the $ 500 you contributed to your daughter's rent last month. The IRS is not really interested in tracking every penny of income that changes hands. The tax code exempts gift loans of less than $ 10,000 from the charged interest rule.

The same limit of $ 10,000 applies to loans related to employment and those made to shareholders. However, the limit does not apply to the donation of income-generating assets. And for loans of $ 100,000 or less, the total amount of interest charged cannot 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 save yourself the headache. Going back to the previous example, give your brother $ 9,999 instead of $ 10,000. One dollar less gets you off the IRS radar.

If you can, you can also consider simply giving the money away instead of a loan. Remember, the IRS also imposes a gift tax, which is also paid by the donor, but the limit is $ 15,000 per person per year beginning in 2020. This limit is known as the annual gift tax exclusion. You can give your brother $ 10,000 tax-free because he is in foreclosure as long as you don't want the money back.

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Source: Lisa Backhaus

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