What Is an Interest-Free or Below-Market Loan?
Loans provided at a rate of interest below the applicable federal rate (AFR), set monthly by the IRS, are called below-market loans. When a loan carries little or no interest, interest may be imputed by the IRS under a series of rules. Interest-free or below-market loans can occur in a number of settings (including corporation-shareholder transactions), but are most frequently found in loans between family members and loans from an employer to an employee. There are, however, a couple of exceptions to the imputed interest requirement.
At one time, loans with below-market interest rates were a popular executive benefit. As a supplement to their regular compensation, employers would often provide their executives with interest-free loans or loans made at a highly favorable rate in order to help their employees purchase homes or engage in other activities. Family members also used interest-free loans among themselves as an alternative to outright gifts; basically, an IOU would be drawn up with no interest required.
In 1984, however, Congress amended the tax laws to clarify that when a loan's interest is below the AFR, interest can be imputed, using the AFR as the appropriate interest rate. In the case of employer-employee loans, if the loan fails to provide for adequate interest, the company is deemed to transfer additional compensation to the employee equaling the forgone loan interest for the period the loan is outstanding. The employee, in turn, is deemed to pay the forgone interest to the company at the AFR rate. The same logic is employed regarding family loans.
What Is The Difference Between a Gift Loan, a Demand Loan, And a Term Loan?
Imputed interest rules differ, depending on the type of loan you have. Therefore, it's useful to review the terminology.
A gift loan is any below-market loan in which the forgone interest is in the nature of a gift. Family transactions most often fall into this category.
A demand loan is any loan that is payable in full at any time on the demand of the lender. It also encompasses any loan with an indefinite maturity, and any loan where the benefit of the interest arrangements is not transferable and is conditioned on the future performance of substantial services by the loan recipient.
A term loan is any loan that is not a demand loan; basically, the loan is payable on a specific date.
On What Date Is Interest Deemed To Be Transferred?
In the case of a demand loan or a gift loan, the imputed interest amount is deemed to be transferred from the lender to the borrower on the last day of the calendar year in each year that the loan carries a below-market rate.
As for a term loan (other than a gift loan), a mathematical formula is employed to figure out the amount of the imputed interest. The lender is generally treated as having transferred on the date the loan was made (and the borrower is treated as having received on such date) cash in an amount equal to the excess of:
- The amount loaned, over
- The present value of all payments that are required to be made under the terms of the loan
These rules are very complicated and beyond the scope of this discussion. Please consult additional resources for more information.
Which Loans Are Exempt From The Imputed Interest Rules?
The following discussion outlines some below-market or interest-free loans that are exempt from the normal imputed interest tax rules.
De Minimis Loans Aggregating Less Than $10,000
In general, the below-market rules do not apply to gift loans between individuals when the aggregate outstanding amount of loans between these individuals does not exceed $10,000. However, this exception does not apply if the loan is directly attributable to the purchase or holding of income-producing assets, such as stocks.
The below-market rules also do not apply to compensation-related loans between employers and employees and corporations/shareholders if the aggregate loans outstanding between the respective parties do not exceed $10,000. (A husband and wife are treated as one borrower for these purposes.)
Net Investment Income Less Than $1,000
In the case of gift loans between individuals where the total amount outstanding does not exceed $100,000, the amount deemed transferred from the borrower to the lender at the end of the year will be imputed to the lender only to the extent of the borrower's annual net investment income. If such income is less than $1,000, no imputed interest is deemed transferred to the lender.
Example(s): Assume Hal makes an interest-free $90,000 loan to his daughter, Jill, so she can start a business. He forgoes $4,000 interest each year. The IRS treats the loan as a $4,000 gift. There is no gift tax, since it is less than the annual gift tax exclusion amount, and Hal owes no tax on the forgone interest if the daughter has $1,000 or less of net investment income. However, if her net investment income is $2,500, for example, then $2,500 must be included as income to the lender, Hal.
Loans to Continuing Care Facilities
Certain below-market loans by individuals to qualifying continuing care facilities, made pursuant to a continuing care contract, are also exempt from the imputed interest rules. In general, this exception applies if the lender (or lender's spouse) attains age 62 before the close of the calendar year.
What Are The Income Tax Consequences of Below-Market Loans?
Regarding intra-family loans, the tax consequences are fairly straightforward. First, it is wise for the lender to have a written note indicating the loan amount, the payment date, the stated rate of interest, and any collateral or security. You should use the AFR interest rate unless you meet one of the exceptions to the imputed interest rules:
- Interest paid by the related borrower is deductible if the loan is spent for business or investment purposes (up to net income). Interest may also be deductible if the loan is secured by a "qualified residence."
- Interest paid by the related borrower is not deductible if the loan is used to pay personal expenses or is used for an unsecured home loan (not secured by the home itself).
Tip: The lender can deduct a bad-debt loss if a bona fide loan is not repaid.
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