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 = 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 these 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 loan amount 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. The corporation may act as an agent, borrowing money from a 3^rd 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 non-gift demand loans or
• non-gift term loans

Demand loans are loans payable on demand; term loans have a stipulated duration. Non-gift term loans are treated as original issue discount (OID), where the OID interest must be reported annually by the lender. Gift loans and non-gift 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 nonspecific types of loans to cover tax avoidance schemes often dreamed up by lawyers and accountants, such as this: The taxpayer joins a health club with annual membership fees of $400. 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.

Some types of commercial loans are not subject to imputed interest rules. 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 next $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.

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.

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 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 $4,000 on the transaction, the IRS requires that the seller report a $96,000 contract price + $4,000 of interest, and $96,000 is the basis to the buyer for the property. The $4,000 interest may be deductible as mortgage 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 these 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 principal of less than $5,070,500 (2024, Ref: Publication 537, Installment Sales), 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 buying 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 $6,734,800 (2023, Ref: Publication 537, Installment Sales), then the minimum required interest is the lower of the applicable AFR or 9% compounded semiannually; for seller financing exceeding 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.