By: Melanie V. DeMarco, Esq.
July 3, 2024
Are you thinking about loaning someone money? You might think you’re being nice when you offer a 0% or low interest loan, however the IRS thinks otherwise. When a someone loans money interest-free or below market rate, the IRS will impute an interest rate and charge taxes based on that imputed interest rate. That means the IRS deems interest to be received, regardless of whether actual interest was paid.
Essentially, the IRS will assign interest income to a transaction when they see that it is below market rate. This is to ensure that taxpayers report income that they would have received if the transaction was made at or above market rate.
Imputed interest applies in several transactions when the loan is over $10,000:
- Below-market: When a loan is offered with little or no interest.
- Gifts: Loans between family members or other related parties.
- Compensation-related: Loans that are part of employment compensation.
The IRS calculates imputed interest based on the current federal rate (AFR). This means that if a loan is made with no interest, the IRS will calculate the hypothetical interest that would have been earned based on the AFR, and charge taxes as if that income had actually been earned. For example, if a person lends $50,000 to a friend at 0% interest, and the applicable short-term AFR is 2%, then the IRS will assume that the person collected $2,000 in interest payments from their friend, and list it on their tax return as interest income, even though the person did not really collect interest.
Failure to comply with imputed interest rules (meaning failure to report interest at the applicable AFR on your loan) may result in taxable penalties. Essentially, the IRS may consider the failure to report interest income at or above market rate – even on interest you didn’t actually receive – as underreporting your income. This means that they have the authority to charge penalties for underreporting or for failing to file the appropriate forms, in addition to the back-taxes owed on the income. Some ways to avoid imputed interest are to structure loans at or above the current AFR, properly documenting your loans, and discussing the tax implications of the transaction prior to offering the loan.
Remember, usually the lender is responsible for paying taxes on imputed interest (or any actual interest income from the loan). If the IRS determines that the loan should have been made at a higher rate, the lender may be required to pay the difference between the two rates. Further, the lender is responsible for reporting the imputed interest on their own tax return, and in most cases, imputed interest is not tax-deductible.
Don’t get caught with unexpected tax liabilities! Consulting with an attorney and/or accountant prior to entering the transaction can help provide guidance on complying with imputed interest rules and help minimize risk of hidden tax charges.
*This form is for general information only and should not be taken as legal advice regarding your specific situation. For personalized advice on IRS imputed interest and related tax implications, consult with a qualified tax professional to ensure compliance and minimize tax risks.