What Is Imputed Interest?
- The IRS establishes on a monthly basis a minimum interest rate that the federal government assumes is charged on a loan, whether the interest is actually collected or not. This is also referred to as "unstated interest" or "original issue discount," according to TheFreeDictionary website. If the lender is neither collecting interest nor paying taxes on the minimum rate and the IRS discovers it, the lender will be forced to pay taxes, penalties and interest charges.
- The IRS publishes the applicable federal rates as revenue rulings on a monthly basis. The AFRs are established based on the length of the loan and the period for compounding. For July 2011, the rates vary from 0.37 percent to 4.92 percent, depending on the type of loan as defined by the IRS; the three types of loans are terms of three years or less, over three but no more than nine years, and over 9 years. Historical rates going back to January 2000 can be found on the IRS website.
- Sellers who privately finance their home buyers must pay close attention to the imputed interest rules. In the past, to avoid the tax, sellers simply increased the price of the home and charged little or no interest; payments the buyer made were reported as principal. However, buyers may now deduct from their gross income the amount of interest that's paid to the seller via imputed interest -- even if the tax is not actually paid to the seller.
- The IRS considers the sale of property as an installment sale if the seller receives even one payment for the property in the tax year following the transfer. The seller is required to report the sale -- assuming the seller doesn't take a loss on the property -- but only needs to report the income earned on the sale during the year on his income tax return. The IRS states that if the contract does not charge adequate interest, then the IRS will count imputed interest toward the seller's income.
