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Imputed interest is a finance charge assigned by tax authorities to loans and investments without declared interest. Tax codes in Europe, Austria, and Hong Kong recognize imputed interest, while in the US, it is assessed against non-interest bearing financial instruments and loans. The applicable federal rate (AFR) determines the minimum amount of interest that must be assigned to different types of loans and investment vehicles. It is advisable to consult a tax professional before making a loan with little or no interest to avoid unforeseen financial consequences.
Most loans and investment instruments consist of two main components; principal and interest. Principal refers to the amount borrowed or invested, and interest is a finance charge paid or received, based on a percentage of the principal. However, some loans and investments do not have declared interest. In these cases, the tax authorities may assign an interest rate and adjust the principal accordingly. Imputed interest is interest that has not actually been paid, but is deemed to have been paid by a governmental authority.
Tax codes across Europe have been revised since the 1980s to address the concept of imputed interest. In some cases, this becomes taxable for the recipient and deductible for the payer. In Austria, the tax codes allow companies to use earned capital interest to reduce their tax base. Hong Kong recognizes imputed interest, but does not tax it or allow it to be used for a deduction.
In the United States, imputed interest is assessed against non-interest bearing financial instruments such as original discount bonds, band bonds, and zero coupon bonds. These are bought at significantly below face value and mature at par. If a person is in a higher tax bracket, it would be beneficial for them to pay only the tax on the bond at maturity, using the lower capital gains tax rate. The Internal Revenue Service (IRS) will not allow this potentially beneficial view, and treats these bonds as interest-bearing by applying taxable chargeable interest. In this way, a portion of the profit is taxed annually as ordinary income.
The same position is taken with personal, commercial and mortgage loans. Again, it might be beneficial for a seller to increase their sales price and offer a low interest rate so that they can benefit from a lower tax liability. To prevent this from happening, the IRS requires an applicable federal rate (AFR) to be applied to all loans of six months or more. The AFR is published monthly and determines the minimum amount of interest that must be assigned to different types of loans and investment vehicles.
If a person charges less than the AFR, the amount of interest that should have been charged is determined using the federal rate. This is the amount that the recipient will claim as income. If the interest paid qualifies as a deduction, such as a business loan or property mortgage, that is the amount the payer will show on your tax return. The difference between the actual interest and the imputed interest will be deducted from the principal of the note.
For example, if an individual receives a one-year, zero-interest loan of $20,000 United States Dollars (USD), their loan will be adjusted for tax purposes to show both principal and interest. If the AFR for that type of loan is 10%, then the $20,000 repayment will be reclassified as a principal payment of $18,182 USD and an interest payment of $1818 USD. The loan would be considered paid in full, but the lender would have to report the imputed interest as income. If the interest on the loan qualified as a tax deduction, the borrower would claim a deduction of $1,818 USD.
In some cases, a person may wish to lend money to a child or other family member for little or no interest. While there are some exceptions for small loans, in the US, these family loans are also subject to the imputed tax rules on interest. To avoid unforeseen financial consequences, it is advisable to consult a tax professional before making this type of loan.
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