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Most loans and investment instruments consist of two primary components; principal and interest. Principal refers to the amount borrowed or invested, and interest is a finance charge paid or received, based upon a percent of the principal. Some loans and investments, however, have no stated interest. In these cases, the taxing authorities may assign an interest rate and adjust the principal accordingly. Imputed interest is that interest which has not actually been paid, but is considered to have been paid by a government authority.
Tax codes throughout Europe have been revised since the 1980’s to deal with the concept of imputed interest. In some cases, this becomes taxable to the recipient, and deductible by the payer. In Austria, the tax codes allow imputed equity interest to be used by companies to lower their taxable 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, strip bonds and zero-coupon bonds. These are purchased significantly below face value and mature at par. If a person is in a higher tax bracket, it would be beneficial for him to only pay 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 imputed interest. In this way, a portion of the gain is taxed yearly as ordinary income.
The same position is taken with personal, business and mortgage loans. Once again, it might be beneficial for a seller to increase his sales price and offer a low interest rate so he may profit from a lower tax liability. To prevent this from happening, the IRS requires that an applicable federal rate (AFR) be applied to all loans of six or more month’s duration. The AFR is published monthly, and determines the minimum amount of interest that should 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 his tax return. The difference between the actual interest and the imputed interest will be deducted from the principal of the note.
For example, if a person receives a one-year, zero interest loan of $20,000 US Dollars (USD), his 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 USD 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 be required to report the imputed interest as income. If the loan interest qualified as a tax deduction, the borrower would claim an $1818 USD deduction.
In some cases, a person may wish to loan 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 imputed interest taxation rules. In order to prevent unforeseen financial consequences, it is advisable to consult a tax professional prior to making this type of loan.