IRS imputed interest rules

Written by phil m. fowler
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IRS imputed interest rules
The IRS can charge you taxes on interest income, even if you are not actually collecting interest on a loan. (tax forms image by Chad McDermott from Fotolia.com)

IRS imputed interest is interest that the IRS creates on a loan, and taxes the lender on, even if the lender is not actually collecting interest. For example, if you lend your daughter £13,000 to be paid back over five years, interest free, the IRS will impute an interest rate on the loan and tax you as if the imputed interest were actually being collected by you as income. For many reasons, then, it makes sense to charge a minimal interest rate on all loans, including loans made to trusted friends and family.

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History

The IRS created the imputed interest rules to prevent wealthy people from avoiding taxes by loaning money to their children in lower tax brackets, then letting the children invest the money so that the investment income would be taxed at the lower rate. The money stays in the family, but instead of being taxed at the wealthy parent's tax rate, the money is taxed at the much lower child's tax rate.

Function

The imputed interest rules apply to loans that are made interest-free, or at a discounted interest rate that is below market. The imputed interest rules prevent the transfer of wealth for the purpose of avoiding higher taxes. Unfortunately, the rules also end up taxing fairly common family loans that are made not for the purpose of avoiding taxes, but for the purpose of just helping out a family member.

Understanding Imputed Interest

In a standard market transaction, such as one involving a bank and a private borrower, the bank lending money will obviously charge interest for making the loan. The interest is the bank's income, and, without it, the bank would not make any profit. Contrast that type of market loan with an inter-family loan. Imagine that a parent lends £13,000 to a daughter for a down payment on a home. Most parents are not in the business of making money on loans to their children, so the parents do not think to charge interest. However, the IRS will "impute" interest on the loan and impose an income tax on the imputed interest. So the parent ends up paying taxes on the imaginary, or "imputed," interest even though the parent is not actually collecting any interest.

Avoiding Imputed Interest

The obvious way to avoid imputed interest is to charge the minimum interest rate on all loans, including loans made to family members. The IRS establishes the minimum interest rates, which vary depending on the size and the term of the loan. The rates are frequently updated, so it is best to check the most current IRS tables, which can be found on the IRS's website -- find a link in the References section. As long as you charge at least the minimum rate listed in the table, referred to as the applicable federal rate, you will not have any problems with imputed interest.

Considerations

Another advantage to charging the minimum applicable federal rate on all loans, including loans to family and friends, is that it requires you to document the loan with at least some paperwork. This paperwork can become important if either you or the person you loan the money to dies, or if the loan cannot be collected. If you loan £13,000 to your daughter, and your daughter cannot pay you back, you will want to write the £13,000 off on your taxes as a bad loan deduction, which can reduce your total taxes paid. If you have not documented the loan, you will not be able to do this. Additionally, you will want documentation explaining whether your daughter must pay the loan back to your estate if you pass away, or whether the loan is to be forgiven. For many reasons, it makes sense to avoid imputed interest by documenting the loan and charging the minimum applicable rate, even to close family and friends.

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