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What happens when you lend money to your family/friend/colleague? Mind you we are not talking about 1000 bucks for a weekend but a sizeable 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 did lend and did not charge any interest as you lend the money in good faith. You being a perfect friend 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?
What is Imputed Interest?
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 imputed or implicit. This imputed interest serves as an instrument for tax authorities to collect tax revenues on loans and securities which either pay no interest or very little interest.
How Imputed Interest Works?
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 and hence calculates tax on it which eventually adds up to your final tax statement.
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What is the Reason for this Implicit Tax?
It came to the notice of Tax authorities that many high bracket tax payers were shifting their income to low bracket relatives or friends. Doing so the authorities believe that these high bracket tax payers were evading tax. This is because in an ideal scenario there would have been taxes on this interest which income tax department is losing out to because of the absence of a structured loan mechanism. There was a considerable increase in such instances which led Congress to enforce new laws that recognize imputed interest as Income. The first such law came through the tax act of 1984.
For example, let’s 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 on it. Also, it has been decided that the child can pay back the amount within 8 years to avoid any burden on his current financial state. 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 would have lent out 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%) which would be added to their interest income in the Tax return calculations. Hence In this scenario, 50,000 dollars will be added as interest income in the IT return sheet for the couple even though not a single penny was paid by the child explicitly.
The concept of imputed interest also applies in the following scenarios:
- Zero coupon bonds 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 value represents the interest the investor has earned during the tenure of the bond. In simple terms, the tax on the imputed interest will be calculated even if the investor has not received any yearly payments.
- Corporates lending money to shareholders. For corporates, this will be an interest income and for shareholders, it will be a dividend income.
- All financial instruments such as loans that may have favorable interest terms and significantly reduce the tax liability of borrower or lender.
- Intrafamily loans that generate unrealistic tax implications.
- Gift loans
- Demand loans
- Compensation related loans, employer to employee. This will be realized as compensation income in the employee tax returns.
Why knowing Imputed Interest is Helpful?
The imputed interest comes into picture when a loan has been given interest-free or on very low interest rates. The IRS publishes this imputed tax rates monthly. Imputed interest rates remove any incentives to exploit the in-house loan transfers and evade any tax exploitation by high bracket tax payers. Knowing imputed interest rates would be helpful in planning your investments better and would avoid any unpleasant surprise in your annual tax filing.
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 howsoever 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. This will make sure that both lender and the borrower are aware of the tax implications, repayment terms and a legal proof in case any issue arises with the tax authorities. This should avoid any last minute adverse tax consequences.
Other important factors to be considered:
- The loan principle should be reasonable considering the financial situations of the borrower and should not raise any suspicion.
- Intent to pay and repayment schedule should be evident in the legal contract.
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, do remember that there is no free lunch and a misunderstanding or overlooking of the same can result in hidden tax penalties for your generous lenders.
Imputed Interest Video
This has been a guide to what is imputed interest? Here we discuss how imputed interest works and the reasons for this implicit tax and why knowing this concept that be very helpful. You may learn more about Corporate Finance from the following articles –