What is Imputed Interest?

Explanation

What happens when you lend money to your family/friend/colleague? Mind you, we are not talking about 1,000 bucks for a weekend but a sizable amount that might be used by the borrower to infuse money into the business, educational loan, to buy a car, or as simple as a personal loan.

Say you lent and did not charge any interest as you lent the money in good faith. Being a perfect friend, you are only concerned about the principal, which you did get after some time as promised by your friend. Although it looks like an in-house transaction between you and your friend, there is more to the story as far as tax authorities are concerned. Even if we ignore the credit risk involved, there can be huge tax penalties that might come as a shock in your tax calculation sheets. Sounds confusing?

The concept of imputed interest refers to the calculation of interest that should have been paid for tax calculations even if there were no actual interest payments between the lender and the borrower. Hence, the name is imputed or implicit. This imputed interest serves as an instrument for tax authorities to collect tax revenues on loans and securities that pay no interest or very little interest.

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How Imputed Interest Work?

Coming back to your example where you lend money to your friend. You might not have charged any interest, but the IT department assumes the interest accrued on the principal as your income. Hence, it calculates tax, eventually adding to your final tax statement.

What is the Reason for this Implicit Tax?

It came to the notice of tax authorities that many high-bracket taxpayers were shifting their income to low-bracket relatives or friends. The authorities believe that these high-bracket taxpayers were evading tax. That is because there would have been taxes on this interest in an ideal scenario, in which the income tax department is losing out to the absence of a structured loan mechanism. A considerable increase in such instances led Congress to enforce new laws recognizing imputed interest as income. The first such law came through the tax act of 1984.

For example, let us say a couple provides a principal amount of $1 million to their child as a loan to buy a new house without charging any interest. Also, it has been decided that the child can pay back the amount within eight years to avoid burdening his current financial state. However, this generous situation might not be sensible for the couple as it might not bring any interest payment because they could have earned an interest income if they had lent this money to some third party.

In this scenario, the IRS would assume that the parents would have collected an annual interest payment (say 5%) added to their interest income in the tax return calculations. Hence, in this scenario, 50,000 dollars will be counted as interest income in the IT return sheet even though the child explicitly paid not a single penny.

The concept of imputed interest also applies in the following scenarios: –

  • Zero-coupon bondsZero-coupon BondsIn contrast to a typical coupon-bearing bond, a zero-coupon bond (also known as a Pure Discount Bond or Accrual Bond) is a bond that is issued at a discount to its par value and does not pay periodic interest. In other words, the annual implied interest payment is included into the face value of the bond, which is paid at maturity. As a result, this bond has only one return: the payment of the nominal value at maturity.read more where the investor does not receive any fixed annual interest payments but the bond itself has been purchased at a discount to the face value. The difference between the discounted price and the maturity valueMaturity ValueMaturity value is the amount to be received on the due date or on the maturity of instrument/security that the investor holds over time. It is calculated by multiplying the principal amount to the compounding interest, further calculated by one plus rate of interest to the period’s power.read more represents the investor’s interest during the bond’s tenure. In simple terms, the tax on the imputed interest will be calculated even if the investor has not received any yearly payments.Corporates lend money to shareholders. So, it will be an interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. read more for corporates. It will be a dividend income for shareholders.All financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more such as loans may have favorable interest terms and significantly reduce the tax liability of the borrower or lender.Intra Family loans that generate unrealistic tax implications.Gift loansDemand loansDemand LoansA demand loan (DL) is a secured loan that has to be repaid by the borrower upon the lender’s demand.read moreThe compensation-related loans from employer to employee. That shall be realized as compensation income in the employee tax returns.

Why knowing Imputed Interest is Helpful?

The best way to avoid any tax implications would be:

  • First, we should understand that no financial loan is interest-free. There is always an imputed interest, however small it may be. A loan of $10,000 should not pose any problem for either party.

But make sure that this limit applies too when you have multiple such loans, and $10,000 is not a threshold for one such individual transaction.

  • Before indulging in any such transaction, have an official contract properly documented where you and the other party agree on a loan tenure fix imputed interest rates and mode of payment. That will ensure that both the lender and the borrower know the tax implications, repayment terms, and legal proof if any issue arises with the tax authorities. In addition, that shall avoid any last-minute adverse tax consequences.

Other important factors to be considered:

  • The loan principal should be reasonable considering the borrower’s financial situation and not raise suspicion.The legal contract’s intent to pay and the repayment schedule should be evident.

Borrowing from someone you know might be a better way of financing as the federal government sets the imputed interest rates at rates far below the market lending rates. However, remember that there is no free lunch, and a misunderstanding or overlooking can result in hidden tax penalties for your generous lenders.

Imputed Interest Video

This article is a guide to Imputed Interest. Here, we discuss imputed interest rates, work, and the reasons why imputed interest is helpful. You may learn more about corporate finance from the following articles: –

  • Double TaxationInterest Expense MeaningCapital Gains vs DividendsNet Operating Loss