Loans Personal Loans What Is Imputed Interest? Imputed Interest Explained in Less Than 5 Minutes By Beverly Bird Beverly Bird Beverly Bird has been a writer and editor for 30+ years, covering tax breaks, tax preparation, and tax law. She also worked as a paralegal in the areas of tax law, bankruptcy, and family law from 1996 to 2010. Beverly has written and edited hundreds of articles for finance and legal sites like GOBankingRates, PocketSense, LegalZoom, and more. learn about our editorial policies Updated on March 19, 2022 Reviewed by Andy Smith Reviewed by Andy Smith Andy Smith is a Certified Financial Planner (CFP), licensed realtor and educator with over 35 years of diverse financial management experience. He is an expert on personal finance, corporate finance and real estate and has assisted thousands of clients in meeting their financial goals over his career. learn about our financial review board Fact checked by Ariana Chávez Fact checked by Ariana Chávez Ariana Chávez has over a decade of professional experience in research, editing, and writing. She has spent time working in academia and digital publishing, specifically with content related to U.S. socioeconomic history and personal finance among other topics. She leverages this background as a fact checker for The Balance to ensure that facts cited in articles are accurate and appropriately sourced. learn about our editorial policies In This Article View All In This Article Definition and Example of Imputed Interest How Imputed Interest Works Do I Need to Pay Tax on Imputed Interest? Alternatives to Earning Imputed Interest Photo: Jamie Grill Photography / Getty Images Definition Imputed interest is interest that a lender is assumed to have received and must report as income on their taxes regardless of whether they received it. It applies to family loans and other personal and business loans extended at no interest or an interest rate the IRS considers to be too low. Definition and Example of Imputed Interest The Tax Reform Act set provisions for applicable federal rates (AFRs) in 1984. This is a minimum interest rate that must be charged on all loans, even personal loans. The IRS publishes the rates online as an Index of AFR Rulings. It changes them monthly to keep pace with the economy. There are different rates for loans of different durations (short-, mid-, and long-term) and with different compounding periods, such as annual, semiannual, quarterly, or monthly. The IRS “imputes” or assigns to lenders the interest income they would have received at AFR rates if they extend a below-market loan. They charge no interest or interest at a rate that's less than the AFR, regardless of whether they actually receive the money. Lenders must enter the "imputed interest," the interest they're considered to have received, on their tax returns as taxable income. Note Most people don’t consider money they lend to family or friends to be official transactions, but the IRS takes the position that all loans should pay at least a minimal amount of interest. The IRS imputes interest income to taxpayers who make loans to ensure that the federal government gets its fair share of all financial transactions, including exchanges of money between family and friends. An Example of Imputed Interest Suppose your sibling has lost their job, and they have a family to support. You lend them $10,000 to help make ends meet. You expect them to repay you over a three-year period when they start a new job, but you don’t charge them interest, because you just want to help out. The AFR for short-term loans of three years or less is 1% at the time, compounded annually. The interest rate you assessed on the gift loan is “below market," because you're not charging any interest at all. You must therefore apply the AFR to the loan balance. The resulting amount is annual interest income. You must report the $100 (0.01 x 10,000) as interest income on your tax return each year. Imputed interest on a small loan isn’t enough to break the bank when you pay your marginal tax rate on it, but you must report and pay taxes on it, even if you never received it. You would still pay taxes as if you had charged at the AFR rate or if you had charged interest at a lower rate than the AFR. The IRS would impute the difference in interest income to you in that case. How Imputed Interest Works Lenders who are most commonly targeted by this law are parents, family members, and friends. They're folks who are just trying to help out in someone's hour of need. The IRS refers to these below-market loans as “gift loans.” Charging zero interest is considered to be a gift, but the IRS still treats the interest that would have been owed at the applicable imputed interest rate as though it had been received. Thus, it's taxable to the lender. Note The imputed interest rule extends beyond loans to family members and friends. A business might front an employee or owner money at no interest under difficult circumstances, for example. The IRS subjects this type of transaction to imputed interest as well. Do I Need to Pay Tax on Imputed Interest? Imputed interest applies when no interest is charged or when a minuscule rate, less than that required by the AFR, is applied. The same imputed interest rule applies if you don’t actually give cash but assign your right to receive income to someone else. Don’t start worrying over that $500 you contributed to your daughter’s rent last month. The IRS really isn’t interested in keeping track of every last cent of income that changes hands. The tax code exempts gift loans of under $10,000 from the imputed interest rule. The same threshold of $10,000 goes for employment-related loans and those made to shareholders. Alternatives to Earning Imputed Interest This isn’t a particularly crippling tax law for small loans. There are at least a few ways you can spare yourself the headache. You can give your sibling $9,999 rather than $10,000. One buck off removes you from the IRS radar. Note The limit doesn’t apply to the gifting of income-producing assets. The total amount of imputed interest can’t exceed the borrower’s net investment income in the case of loans of $100,000 or less. You might also consider simply giving the money as a gift, rather than as a loan, if you can afford it. The IRS also imposes a gift tax that's payable by the donor, but the annual cap is $16,000 per person in 2022, up from $15,000 in 2021. This threshold is referred to as an "annual exclusion from the gift tax." You can give your sibling $10,000 tax-free, because it’s under the exclusion, as long as you don’t want the money back. Key Takeaways Imputed interest is interest the IRS assumes a lender has received. It's subject to taxation regardless of whether the lender has actually received it.The rule applies to below-market loans that impose no interest or too little interest.Rates change every month. They vary based on loan duration and compounding intervals.Lenders can avoid imputed interest on below-market “gift loans” by keeping loans under $10,000. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. The Joint Committee on Taxation. "JCS-30-84," Download "JCS-30-84," Pages 10-12. IRS. “Section 1274—Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property," Page 2. U.S. Small Business Administration. "5 Tax Rules for Deducting Interest Payments." IRS. "Adjusted Applicable Federal Rates and Adjusted Federal Long-term Rates," Page 2. IRS. "Publication 550 (2021), Investment Income and Expenses." Michigan Society of Enrolled Agents. “Imputed Interest,” Pages 2-3. IRS. "Frequently Asked Questions on Gift Taxes."