Imputed Interest Explained

[Randy Rodenhouse]

What is imputed interest? This was a term I was familar with but recently became got a deeper knowledge of when advising someone on how to structure a seller carry back note. He had found a house where the seller was willing to finance (often referred to as seller finance or owner finance) and the seller was willing to do a 0% interest rate loan where all payments went toward principal paydown. Now this persons attorney was advising that he do the loan for 2-3% to avoid some issues concerning imputed interest.

So what is imputed interest? Imputed interest refers to the interest that is considered to have been earned on a loan or investment, even if no actual interest has been paid or received. For example, if you borrow money from a friend or family member and they don't charge you any interest, the IRS may still consider it as if you had received interest on the loan. This imputed interest is treated as taxable income and you may need to report it on your tax return.

So the next question is what interest rate is acceptable? 
In summary, imputed interest is a way for the IRS to ensure that taxpayers are not avoiding taxes on loans or investments that don't pay interest. The IRS publishes the Applicable Federal Rates (AFR) which are a set of interest rates which are used to determine the minimum interest rates that must be charged on certain loans or financial transactions to avoid triggering tax consequences (see graph below)

AFRs are used to determine the amount of imputed interest on loans that have below-market interest rates, such as loans between family members or friends. The IRS sets different AFRs based on the length of the loan and the type of transaction.

In summary, imputed interest is a way for the IRS to ensure that taxpayers are not avoiding taxes on loans or investments that don't pay interest.