How do I? Calculate imputed interest on below market rate loans
Loans without interest or at below market interest rates are re-characterized so that the lender must recognize market-rate interest income. Put another way, a below market rate loan is a loan for which a rate of interest that is lower than the applicable federal rate (AFR) (which is computed by the government and released by the IRS on a monthly bases). Special adjustments might be necessary to determine the interest rate on short period loans, variable rate loans, and loans denominated in foreign currencies.
Categories of below market rate loans. The below market loan rules apply to a loan within one of six categories:
- gift loans;
- compensation-related loans;
- corporation-shareholder loans;
- tax avoidance loans;
- loans to qualified continuing care facilities; or
- other below-market loans.
A below market loan is further characterized as either a demand loan or a term loan:
Below market demand loans. Below market demand loans are restructured for tax purposes so that the foregone interest is treated as transferred from the lender to the borrower, either as a gift, charitable contribution, dividend, compensation, or other payment, and re-transferred by the borrower to the lender as interest. The foregone interest attributable to each calendar year is treated as transferred and re-transferred on the last day of that year.
Below market term loans. Below market loans other than gift or demand loans are term loans, which are restructured for tax purposes so that the excess of the loan amount over the present value of all required loan payments, that is, the loan’s original issue discount (OID), is treated as transferred from the lender to the borrower on the date of the loan. The lender and borrower recognize the interest under the OID rules over the life of the loan.
The principal distinction between the treatment of a gift or demand below market loan and a term below market loan, therefore, is in the timing of the consideration deemed transferred by the lender to the borrower. In both instances, the borrower is treated as paying interest and the lender as receiving interest income.
The below market loan rules include several exceptions and exemptions. There is a $10,000 de minimis exception for gift loans, compensation-related loans, and corporation-shareholder loans. Israeli bonds, loans between an employer and an employee stock ownership plan (ESOP), and loans to qualified continuing care facilities are also excepted from the rules. For gift loans directly between individuals, the imputed interest payment cannot exceed the borrower’s net investment income for the borrower’s tax year. Special rules apply to below-market employee relocation loans, loans from foreign persons, loans between spouses, and interest obligations that are cancelled, waived or forgiven. A lender must attach a statement to an income return that reports income or deductions arising from below market loans.
If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.