Lend someone money at zero interest, and you don't make any profit from the deal. Therefore, you might assume that the loan doesn't have any tax implications for you. In many cases, though, you'd be wrong. The tax code expects you to charge a certain amount of interest for a loan—and even if you don't, you can be taxed as if you did. The IRS refers to this as "imputed interest."
Imputed interest comes into play when someone makes a "below-market" loan. That's a loan with an interest rate below a certain minimum level set by the government, known as the Applicable Federal Rate, or AFR.
Every month, the IRS publishes a list of current Applicable Federal Rates, which reflect market conditions. For example, in June 2018, the AFR for loans of less than 3 years was 1.78%. If you loan someone money at no interest, or at 0.25%, or at any rate below 1.78%, you have to deal with imputed interest.
How imputed interest works
Imputed interest is interest that the tax code assumes you collected but you didn't actually collect. For example, say you loan a friend $20,000 for one year at 0.1% interest. That friend will pay you $20 in interest ($20,000 x .001 = $20).
But if the AFR for that type of loan is 0.64%, then you should have collected $86 ($20,000 x .0064 = $128). The difference—$128 - $20 = $108—is imputed interest, and you must report it as taxable income and pay taxes on it.
Rationale for imputed interest
The tax code calls for imputed interest because some people and organizations have tried to dodge taxes by portraying large gifts, additional compensation, dividends and other taxable payments as loans.
As explained by Seattle accountant and tax specialist Scott Usher, the government expects loans to be "structured in a business-like manner," including interest rates that reflect market conditions. The idea is that if you're not charging and collecting a certain level of interest, the government isn't going to take your word for it that this is a loan.
What kinds of loans have imputed interest
The rules for below-market loans apply to several kinds of loans:
- Gift loans—loans between friends and family members other than spouses.
- Compensation-related loans—loans from an employer to an employee or independent contractor.
- Loans from a corporation to one or more of its shareholders.
- Any loan made specifically to reduce someone's tax responsibility.
- Certain loans made to continuing care facilities under a contract.
Key exceptions to the rules
The tax code provides a couple notable exceptions to the imputed interest rules:
- Gift loans of less than $10,000 are exempt, as long as the money isn't used to buy income-producing assets.
- Compensation-related and corporation-shareholder loans under $10,000 are also exempt if the lender can demonstrate that tax avoidance wasn't the purpose of the loan.
Loans "without significant tax effect" are also exempt. The IRS provides several examples in Publication 550, which describes sources of taxable income. Such loans include, among others:
- Government-subsidized loans, like student loans.
- Loans provided by a lender to the general public that are consistent with the lender's normal business practices (such as no-interest financing on an auto loan or a zero-interest period on a credit card).
- Loans to help an employee relocate.
- Loans from a non-U.S. citizen that wouldn't otherwise be subject to U.S. tax law.