What Is Imputed Interest on a Loan?
Imputed interest only becomes an issue when a loan has a low interest rate. It refers to the interest rate that the Internal Revenue Service (IRS) uses to calculate the amount of tax to impose on the lender. Imputed interest often affects loans between family members or friends.
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Interest Income Tax
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When a lender extends funds to a borrower, the borrower usually pays back the money with interest. The interest compensates the lender. The IRS considers the loan interest as the lender's income and taxes it.
Imputed Interest
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The IRS assumes that lenders receive at least a minimum interest rate. If a lender charges less than the minimum, the IRS will impute interest on the loan. This means that the IRS assumes the lender receives a certain interest and taxes that amount. The imputed interest rate depends on the government's cost of borrowing and may change every month. According to USA Today, imputed interest serves to prevent parents investing money in their children's names to take advantage of their lower tax brackets.
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Loan Characteristics
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Imputed interest applies only to long-term loans above $10,000. Even if the lender charges little or no interest, he does not have to pay taxes on the interest if the loan amount is $10,000 or less. The lender also does not have to pay taxes if the borrower pays the entire amount back in one year or less. If the loan amount is less than $100,000 and the borrower has investment income of $1,000 or less, the lender also does not have to pay taxes on imputed interest income.
Gift Tax
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The lender may avoid paying taxes on imputed interest income by declaring the interest as a gift. However, the lender can only provide a gift to the borrower up to a certain amount each year. If the gift amount exceeds the limit, the lender has to pay taxes on the excess. The IRS sets the gift tax limit, which may change from year to year.
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