Imputed Interest On Below-Market Loans
Imputed interest rules were designed to prevent high bracket taxpayers from shifting income to lower bracket relatives. Before 1984, income could be shifted between taxpayers with interest-free loans. For example, a mother has $100,000 invested in a bond. She wants to keep the bond but allow her son to earn the interest, so she gives the bond to her son in exchange for a non-interest-bearing note payable to the mother on demand. The mother retains the right to receive $100,000 while the son earns income from the bonds. Significant tax savings are realized if the son is in a lower tax bracket than his mother.
To prevent this type of scenario, Congress implemented new tax rules that recognize imputed interest as income. Tax law treats the imputed interest as a gift that was earned by the mother and given to the son. Although there may also be a gift tax liability on the mother, the mother must recognize the interest as income while the son is considered to have received the gift for which he does not pay taxes. Imputed interest is recognized as income when below-market interest rates are charged for either loans (IRC §7872) or seller-financed sales of property (IRC §1274, §483).
The rate of imputed interest, which must be compounded semiannually on any applicable loans, is calculated using the 3 applicable federal rates (AFR) published monthly by the IRS:
- short term loans, where loan term ≤ 3 years, including demand loans
- mid-term loans, where 3 years < loan term ≤ 9 years
- long-term loans, where loan term > 9 years
If the rate of interest charged is less than the AFR, then the imputed interest is equal to the difference. Imputed interest rules apply to:
- gift loans;
- compensation related loans, such as employer loans to employees;
- corporation shareholder loans, where a corporation lends money to its shareholders;
- tax avoidance loans that significantly lessen either party's tax liability.
Compensation related loans are considered a compensation expense to the employer and compensation income to the employee. Loans by a corporation to its shareholders are considered interest income to the corporation, while the borrowers receive dividend income. So that the IRS will see a loan as a bona fide loan, the loan should have the following characteristics:
- based on a written instrument with the repayment schedule or a note payable on demand
- intent to repay the loan as evidenced by the loan agreement
- the amount of the loan must be reasonable considering the employee’s salary or compensation
If the loan is to a shareholder-employee, then it could be interpreted as a dividend. In some cases, the corporation acts as an agent, borrowing money from a 3rd party, then lending the money to shareholders or employees. In these cases, the IRS will interpret the transaction as a dividend paid to the borrowers, who then paid the interest on the loan.
How below-market loans are taxed depends on their type:
- gift loans and nongift demand loans or
- nongift term loans
Demand loans are loans that are payable on demand; term loans have a stipulated duration. Nongift term loans are treated as original issue discount (OID), where the OID interest must be reported annually by the lender. Gift loans and nongift demand loans are taxed to the lender on the difference between the applicable AFR and the actual rate charged.
A blended annual rate, published by the IRS each July, may be used for a demand loan with an unvarying principal that was outstanding for the entire calendar year. If the loan balance varied or it was not outstanding for the whole calendar year, then the regular imputed interest rules apply.
Tax avoidance loans are a nonspecific type of loan to cover tax avoidance schemes that are often dreamed up by lawyers and accountants, such as the following. The taxpayer joins a health club with membership fees of $400 per year. The taxpayer can make an arrangement to give the health club a $5,000 deposit on which it can earn 8% interest which would be equal to the $400 membership fee. This arrangement allows a taxpayer to earn the benefit of the interest without paying any taxes on it.
There is a specific type of commercial loan that does not fall under the compass of the imputed interest rules — prepayments. If a business receives prepayments that are included in the business's income under its method of accounting, then the prepayments are not subject to imputed interest rules.
Imputed interest rules also do not apply to:
- gift loans of $10,000 or less (aka de minimis loans), unless it is used to purchase income producing property, in which case, the following $100,000 rule applies.
- loans of $100,000 or less. If the loan is used to purchase investment property, then imputed interest rules do not apply if the net investment income from the property does not exceed $1,000.
If net investment income exceeds $1,000, then the gross investment income is the lesser of the imputed interest, as calculated by using the AFR, or the actual gross income earned, since the objective of the imputed interest rules was to prevent income shifting. Net investment income is gross income from all investments minus related expenses.
Net Investment Income = Gross Investment Income – Investment Expenses
If Net Investment Income ≤ $1,000 then Imputed Interest = 0
Else: Net Investment Income = Lesser of (Imputed Interest Computation or Actual Gross Investment Income) – Investment Expenses
However, if the primary purpose of the $100,000 loan was tax avoidance, then the interest is imputed and not limited by the borrower's net investment income, since the purpose of the imputed interest rules was to prevent high tax-bracket taxpayers from shifting income to lower bracket relatives.
Example: $100,000 Exception to Imputed Interest Rules
You make a $100,000 interest-free loan to your daughter payable on demand. Your daughter's gross investment income for the year is $5,000 and her investment expenses total $300. Assuming that the AFR on a short-term loan is 4%, then, for the 1st tax year (remember that tax law stipulates that imputed interest be compounded semiannually):
- Net Investment Income = $5,000 – $300 = $4,700
- For 1st Half Year: Imputed Interest = $100,000 × .04 × .5 = $2,000
- For 2nd Half Year: Imputed Interest = $102,000 × .04 × .5 = $2,040
- Imputed Interest for the Entire Year = $2,000 + $2,040 = $4,040
- Therefore, Net Investment Income = Lesser of ($4,040 or $5,000) – $300 = $4,040 – $300 = $3,740
You must report the $3,740 of net investment income for the year on your tax return. Your daughter does not have to report the income, since tax law deems the net investment income to be a gift. If your gift was for more than the gift tax annual exclusion, then you would also have to report the value of the gift minus the exclusion on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return.
Loans to relatives can still be beneficial, even if imputed interest rules apply, since the AFR is usually far below the interest rates that most lenders would charge to consumers, especially since the target interest rate set by the Fed is so low.
Required Minimum Interest on Seller-Financed Sales
As the federal government considers the AFR as the lowest required minimum interest rate, the IRS will impute ruled interest at any rates lower than that. If the sales contract does not stipulate sufficient interest, then imputed interest will require both the buyer and seller to treat part of the contract price as interest. So if investment property is sold as an installment sale for $100,000, but no interest is charged, then, if the imputed interest is $4000 on the transaction, then the IRS requires that the seller report a $96,000 contract price plus $4000 of interest, which will also serve as the basis to the buyer for the property and the $4000 interest may be deductible if it is a transaction where the buyer is permitted to deduct interest.
IRC §483 applies to contracts where all payments are due at least 6 months after the date of sale and some or all the payments are due more than 1 year after the sale, unless the sales price does not exceed $3000. This rule applies to:
- sales or exchanges of principal residences
- any property where total payments, including interest or other consideration received by the seller cannot exceed $250,000
- farms where the total price does not exceed $1 million
- land sales between family members if the aggregate sales price of all sales between the same parties in the same year does not exceed $500,000.
If the selling price exceeds the aforementioned limits, then IRC §1274 governs if some or all the payments are due more than 6 months after the sale date, but can also apply to debt instruments or property that is not publicly traded, if some payments are deferred more than 6 months.
When the interest is reported depends on the applicable tax section: under §483, the regular reporting method for imputed interest is used; under §1274, OID accrual rules apply, even if the taxpayer is on a cash basis. However, the parties can choose the cash method and avoid the OID accrual rules to report interest if the seller financing is using a cash method debt instrument with a stated principle of less than $4,246,200 (2019), and if:
- the seller is not a dealer in the property sold and is on a cash basis
- both buyer and seller elect to use the cash method, which will bound any successor, but if the lender transfers his interest to an accrual basis taxpayer, then interest is taxed under the accrual method rules thereafter.
However, imputed interest rules do not apply to the purchase of a residence for personal use, so the buyer may not deduct the imputed interest, but only the contract stipulated interest, for the home mortgage interest rules.
The imputed interest rules also do not apply to debt assumed as part of the sale or exchange, or property subject to debt, if the terms of the debt instrument or the nature of the transactions is not changed.
Imputed interest rules do not apply if the AFR is no lower than the lowest AFR for the 3-month period ending on the month of the sales contract agreement or ending on the month of sale. A lower interest rate can be used if it can be shown that the borrower could have gotten a loan on the same terms in an arm's-length transaction.
If seller financing uses a debt instrument qualified under §1274A (B) with the stated principle not exceeding $5,944,600 (2019), then the minimum required interest is the lower of the applicable AFR or 9% compounded semiannually; for seller financing that exceeds this amount, the minimum interest rate is the AFR. The seller financing limit safe harbor is indexed for inflation annually. For seller-financed sale-leaseback transactions, the interest rate must be at least 110% of AFR.
For sales of land between family members, and if the aggregated overall sales to the same family members did not exceed $500,000 during the calendar year, then the lower of 6% compounded semiannually or the applicable federal AFR must be charged; for sales prices exceeding $500,000, the lower of 9% or the AFR rule applies.