4.31 Interest-Free or Below-Market-Interest Loans
For many years, the IRS tried to tax interest-free or below-market-interest loans. However, court decisions supported taxpayers who argued that such loans did not result in taxable income or gifts. To reverse these decisions, the IRS convinced Congress to pass a law imposing tax on interest-free or low-interest loans made by individuals and businesses. You may not make interest-free or low-interest loans to a relative who uses the loan for personal or investment purposes without adverse income tax consequences, unless the exception discussed in this section for $10,000 or $100,000 loans applies.
Caution
How the imputed interest rules work.
If interest at least equal to the applicable federal rate set by the IRS is not charged, the law generally treats a below-market-interest loan as two transactions:
In applying the imputed interest rules, all loans to or from a husband are combined with all loans to or from his wife; they are treated as one person.
With gift loans between individuals, interest computed during the borrower’s taxable year is treated for both the lender and the borrower as transferred on the last day of the borrower’s taxable year. Treasury regulations to Section 7872 provide rules for figuring “foregone” interest. Where a demand loan is in effect for the entire calendar year, a “blended annual rate” issued by the IRS to simplify reporting may be used to compute the imputed interest. The blended annual rate is announced by the IRS each July. For 2012, the blended rate is only 0.22%. The blended rate is not available if the loan was not outstanding for the entire year or if the loan balance fluctuated; computations provided by Treasury regulations must be used.
Charging the applicable federal rate avoids the imputed interest rules.
Gift loans qualifying for the $10,000 and $100,000 exceptions are not subject to imputed interest rules. For other loans, the rules imputing income to you as the lender may be avoided by charging interest at least equal to the applicable federal rate. Applicable federal rates are set by the IRS monthly and published in the Internal Revenue Bulletin; you can also get the rates from your local IRS office. For a term loan, the applicable rate is the one in effect as of the day on which the loan is made, compounded semiannually. The short-term rate applies to loans of three years or less; the mid-term rate to loans over three and up to nine years; the long-term rate applies to loans over nine years. For a demand loan, the applicable federal rate is the short-term rate in effect at the start of each semiannual period (January and July).
Different computations for different types of loans.
There are two general classes of loans: (1) Gift loans, whether term or demand, and nongift demand loans, and (2) nongift term loans.
The distinction is important for figuring and reporting imputed interest. For example, in the case of nongift term loans, the imputed interest element is treated as original issue discount (4.19).
Gift loans and nongift loans payable on demand.
As a lender, you are taxable on the “foregone interest,” that is, the interest that you would have received had you charged interest at the applicable federal rate over any interest actually charged. The borrower may be able to claim an interest deduction if the funds are used to buy investment property (15.10).
Nongift term loans.
A term loan is any loan not payable on demand. As a lender of a nongift term loan, you are taxable on any excess of the loan principal over the present value of all payments due under the loan. The excess is treated as original issue (OID) which you report annually as interest income (4.19).
Reporting imputed interest.
Imputed interest is generally treated as transferred by the lender to the borrower and retransferred by the borrower to the lender on December 31 in the calendar year of imputation and is reported under the regular accounting method of the borrower and lender.
Certain Loans Are Exempt From Imputed Interest Rules
The $10,000 gift loan exception.
In the case of a gift loan to an individual, no interest is imputed to any day on which the aggregate outstanding amount of all loans between the parties is not over $10,000, provided the loan is not attributed to the purchase or carrying of income-producing assets. If the exception applies, there are no income tax or gift tax consequences to the loan.
The $100,000 gift loan exception.
No interest is imputed on an interest-free or low-interest loan to an individual of up to $100,000 if the borrower’s net investment income is $1,000 or less; see the following Examples.
Planning Reminder
Exceptions for compensation-related loans.
For compensation-related and corporate-shareholder loans, the imputed interest rules do not apply to any day on which the total amount of outstanding loans between the parties is $10,000 or less, provided the principal purpose of the loan is not tax avoidance. Certain low-interest loans given to employees by employers to buy a new residence in a new job location are exempt from the imputed interest requirements.
Loans to continuing care facilities.
Senior citizens moving into a community with a continuing care facility are required to pay a fee to the facility. The fee may be treated as a “loan” subject to the imputed interest rules but loans to qualified continuing care facilities are completely exempt (34.11).