IRS Imputed Interest Rules | IRS Tax Advice
IRS Imputed Interest Rules | IRS Tax Advice
What Is IRS Imputed Interest?
Any interest which the IRS has created on a loan and which the lender is taxed on, despite the lender not charging the interest to the debtor is referred to as “imputed interest.” For example, you can loan your daughter or son $10,000 and let them pay the loan off over 5 years without charging any interest. However, the IRS will impute an arbitrary rate of interest and consider it as taxable income, adding this to your tax liability. Therefore, even if you loan money to family members, you should still charge minimal interest on that loan.
Tax Help: Understanding How Imputed Interest Works
With standard market transactions, especially those transactions between a bank or another lending institution and a borrower, there will obviously be some interest charged on that loan. This is one of the ways that banks and lending institutions make their money and stay in business. When you contrast this with a loan between family members, the tax liability factors come into play if you do not charge that family member any interest on the loan as was discussed in the prior section.
Since most parents are not in the business of earning a living by making money off of their daughters and sons, they overlook the need to charge them even a slight amount of interest on any inter-family loans. Unfortunately, this creates a tax liability for you because of imputed interest that the IRS will levy against you. This basically means that you are taxed on imaginary interest that doesn’t really exist and is being collected while the family member is repaying the loan.
How Can Someone Avoid Being Charged Imputed Interest?
Obviously, the primary way in which you should avoid being charged imputed interest is to charge anyone a slight amount of interest to begin with, even if they are family members. Remember that the IRS is going to charge the standard rate of interest based on the size and the terms of the loan. Consult the IRS tables, as they frequently update these.
It is recommended that you charge the minimum amount of interest that the IRS lists in this table, referred to as the “applicable federal rate of interest”, in order to avoid being charged the taxes on the imputed interest. Many sites offer “Tax Tools & Resources” sections to help you with those kinds of questions. Most importantly, if you are considering lending money to a family member or friend, you should probably consult with your licensed income tax professional or a tax attorney to assist you with this.
IRS Tax Advice
Reaching out to a professional to get IRS tax advice is very important, especially in those types of situations where you can increase your tax bill by a large amount without knowing it. Loans to family members should be handled with care. For example, you have to have documentation to prove to the IRS that the loan is not a gift, and that means requirements must be attached to it, such as interest rates, an agreed-upon payment schedule and a letter from the borrower certifying (with proof of income and expenses) that he/she is capable of fulfilling his financial obligations. If you can’t show this kind of proof, the IRS may decide that instead of a loan, that money was a gift and the rules on gift taxes will apply: the lender is usually the one required to pay these taxes.
Clearly, if you’re asked for a loan by a family member, you should definitely take your time and look into all the implications that transaction can have on all the parties involved, because you may need serious tax preparation help come tax filing time. Furthermore, family loans can damage personal relationships and cause income tax and estate planning problems. Because of the complexity of the imputed interest rules and the related exceptions, it’s wise to work with a CPA or tax professional in structuring loans to family members.
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