When you sign a promissory note to borrow money, you are entering into a business transaction with the lender. For tax purposes, the default assumption is that the interest rate you’ll be paying on this loan will be around the market interest rate for similar transactions. But if you’re not paying interest, or paying a much lower rate than the market rate, that is called imputed interest.
If the stated interest rate, or the interest rate you will be paying on the loan, is substantially lower than the market interest rate, or none at all, Internal Revenue Service rules still want you to record the transaction using an interest rate that is close to the market rate. That’s for tax purposes. You'll want to keep a written record of this transaction in case the IRS has any questions.
What is Imputed Interest?
Imputed interest applies to all financial transactions that have favorable interest terms that may cause unrealistic tax implications. For example, an interest-free loan from family or friends, or discounted bonds purchased at less than face value, will likely require you to determine the imputed interest rate to report to the IRS.
If your friend lends you money, he or she will likely need to report interest income based on an imputed rate designated by the IRS. The IRS publishes imputed tax rates each month. This is known as the Applicable Federal Rate or AFR. This is supposed to prevent exploitation of taxable income.
How is Imputed Interest Calculated?
So your parents decide to lend you $100,000 interest-free to buy a house, with a promissory note to pay back the loan in 10 years. If the short-term federal interest rate is 2 percent, the amount of interest you would owe is $100,000 multiplied by .02 which equals $2,000. The IRS would want this income reported on your parents’ tax return, even though your parents have not received interest from you.
In another example, your friend lends you $30,000 to help you get through a rough patch in your business, and the promissory note states that the loan must be paid in full in 10 years. If the short-term federal interest rate is 1.5 percent, your friend will need to report $450 of taxable income for each of the 10 years of the loan, or $30,000 multiplied by .015 percent.
You could also borrow the money at an interest rate that is much lower than the market rate. The same principle would apply to the difference between the market interest rate and the lower rate you have been given.
Recording the Promissory Note
You will then want to record the transaction where repayment of the debt varies considerably from the market interest rate. Each year, in a ledger format, record the beginning value of the loan and the market interest rate. Figure out the length of the loan and the AFR. Record the interest amount that would be paid, whether monthly or annually. As each month or year goes by, record this information on the ledger in clearly delineated columns. You will then have a written record of your imputed interest.
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