The Internal Revenue Service perks up whenever a taxpayer extends a loan to a friend or a family member. You must charge reasonable interest -- if you don’t, it can come back to haunt you at tax time. The IRS wants individuals to treat loans just as lending institutions do, as a bona fide business arrangement, so imputed interest rules kick in to make sure the IRS gets its fair share of taxes. The IRS assumes the borrower paid you the interest and requires you to pay taxes on the appropriate amount.
Applicable Federal Interest Rates
When you loan money to someone, you must charge him interest at applicable federal rates, even if he’s your next of kin. These rates are a little complicated but they’re not a mystery because the IRS posts them monthly on its website. If you charge less than the amount posted in the month you lend money, the loan is said to be “below market.”
Assuming you charged some amount of interest on the loan, you must report it as income at tax time. This is why the IRS is so interested in the transaction. It doesn’t want to lose tax dollars just because you have a good heart, so it imputes interest income to you. Imputing means that the IRS presumes you did receive the money, even if you didn’t. The only way to avoid IRS involvement is to charge the applicable federal rate in the first place.
The IRS expects you to claim as income the difference between the Applicable Federal Rate and the interest you actually received. And, of course, you also have to claim the interest you did receive so the extra imputed interest rule makes the IRS whole again. You’re claiming the same amount of interest income that you would have if you had charged the federal rate. If you didn’t charge interest at all, you must claim the entire Applicable Federal Rate.
Gift Tax Implications
To add insult to injury, there’s a chance that you might end up having to pay a gift tax on the imputed interest as well. Because you didn’t actually charge the full amount of interest that you were supposed to, the IRS considers the imputed interest to be a taxable gift made to the person to whom you made the loan. But the interest would have to amount to more than $14,000 over the course of the year because the IRS allows you to give this much money to one person per year tax-free as of 2015.
Exceptions to the Rule
Imputed interest rules don’t affect the average concerned parent who loans his adult child a few thousand dollars to catch up on credit card bills. The IRS doesn’t impute interest on loans of $10,000 or less. But there’s a catch. The total value of all the loans you’ve made to this individual must be $10,000 or less, so if you make a loan to your child for $5,000 one month, then $6,000 a few months later, you’ve gone over the $10,000 exemption on the date you made the second loan. Even so, you might qualify for another exemption if the recipient uses the money to purchase something that will enable him to earn income. Yet another exemption applies to loans of up to $100,000 if the recipient uses the money to start a business or buy a home. In this case, the amount of imputed interest you’d be taxed on is limited to no more than the recipient’s net investment income for the year. If that happens to be less than $1,000, the IRS won’t assess imputed interest against you.