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.

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image Caution
Get Professional Advice To Draft Loan Agreement
Given the complexity of the imputed interest rules and exceptions, you and your tax advisor should carefully review regulations to the Internal Revenue Code Section 7872 when drafting a loan agreement.
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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:

1. The law assumes that the lender has transferred to the borrower an amount equal to the “foregone” interest element of the loan. In the case of a loan between individuals, such as a parent and child, the lender is subject to gift tax on this element; in the case of a stockholder borrowing from a company, the element is a taxable dividend; in the case of a loan made to an employee, it is taxable pay.
Note: For gift tax purposes (39.2), a term loan is treated as if the lender gave the borrower the excess of the amount of the loan over the present value of payments due during the loan term. Demand loans are treated as if the lender gave the borrower annually the amount of the foregone interest.
2. The law assumes that imputed interest equal to the applicable federal rate is paid by the borrower to the lender. The borrower may be able to claim a deduction for the interest if the loan is used to buy a home and the loan is secured by the residence (15.1), or the loan is used to buy investment property (15.10).

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.


EXAMPLE
On January 1, 2012, Jones Company makes a $200,000 interest-free demand loan to Frank, an executive. The loan remains outstanding for the entire 2012 calendar year. Jones Company has a taxable year ending September 30. Frank is a calendar year taxpayer. For 2012 the imputed compensation payment and the imputed interest payment are treated as made on December 31, 2012.

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.

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image Planning Reminder
Gift Loans up to $100,000
If you give a child or other individual an interest-free or below-market-interest loan, such as to buy a home or start a business, imputed interest is limited or completely avoided provided (1) the total outstanding loan balance owed to you by the borrower at all times during the year does not exceed $100,000, and (2) avoidance of federal tax is not a principal purpose of the interest arrangement.
If the above tests are met, imputed interest is limited to the borrower’s net investment income where that income exceeds $1,000. If the borrower’s net investment income is $1,000 or less, it is treated as zero, so no interest is imputed.
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EXAMPLE
On January 1, 2012, you make a $100,000 interest-free loan to your son, payable on demand, which he uses for a down payment on a home. This is the only outstanding loan between you and your son. Your son’s net investment income for 2012 is $650. Since the loan does not exceed $100,000, and your son’s net investment income does not exceed $1,000, you do not have to report the “foregone interest” as interest income. Imputed interest is limited to the borrower’s net investment income and net investment income of $1,000 or less is treated as zero.
For gift tax purposes, the foregone interest is a taxable gift. Using the IRS blended annual rate for 2012 of 0.22%, the foregone interest of $220 ($100,000 × 0.22%) is a taxable gift, but if this was your only gift to your son in 2012, there would be no gift tax, and a gift tax return would not have to be filed because of the annual gift tax exclusion of $13,000 per donee (39.2).

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).

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