# Imputed Interest: Definition, Calculation, and Key Tax FAQs

![Imputed Interest: Interest the IRS considers paid for tax purposes, even though the debtor has made no interest payments.](https://www.investopedia.com/thmb/YvUG1YwCXegUsDwXl-nVKRNv3JM=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/imputedinterest.asp-1-FINAL-1-637ceb45b63543f2a7565a8a6ce77bdb.png)

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## What Is Imputed Interest?

Imputed interest occurs when a lender charges no interest or an interest rate below market conditions, yet the IRS taxes the implied rate. This tax concept often applies to family loans and bonds sold below face value. Understanding imputed interest helps prevent tax avoidance by ensuring proper reporting and compliance with IRS regulations.

### Key Takeaways

*   Imputed interest is the interest assumed by the IRS on a loan with no or below-market interest rates for tax purposes.  
    
*   The IRS uses applicable federal rates to determine the minimum interest rate for loans, ensuring imputed interest is taxed correctly.  
    
*   Loans between family members under $10,000 may be exempt from imputed interest, provided they are not used for income-generating assets.  
    
*   Zero-coupon bonds owe imputed interest tax on the difference between the discount purchase price and the face value.  
    
*   It's crucial to consult a tax professional regarding imputed interest as exemptions and tax treatments can vary based on individual circumstances.

## How Imputed Interest Works

Imputed interest occurs when a taxpayer has borrowed money but the lender charges no interest or an interest rate that is much lower than the market rate. The tax treatment of such loans depends on whether the loan was an actual loan, a demand loan, or a gift from friends or family. This distinction matters because tax authorities handle each loan type differently regarding imputed interest.

The IRS considers an actual loan to occur when there is a written agreement between the lender and borrower. In this case, the lender may be required to pay taxes on interest income, whether or not they actually charged a market interest rate. Submission of written records helps the IRS determine whether the loan is a conventional loan, as opposed to a gift loan.

Imputed interest may therefore apply to loans among family and friends. For example, a mother loans her son $50,000 with no interest charges. If the applicable short-term federal rate is 2 percent, the son should pay his mother $1,000 annually in interest. The IRS assumes the mother collects this amount from her son and lists it on her tax return as interest income even though she did not collect the funds.

> **Important**
>
> Gift loans of less than $10,000 are exempt from imputed interest, as long as the money isn't used to buy income-producing assets.

## Role of Applicable Federal Rates in Imputed Interest

Because there were many low-interest or interest-free loans that went untaxed, the IRS established applicable federal rates through the Tax Act of 1984. The applicable federal rate ([AFR](https://www.investopedia.com/terms/a/applicablefederalrate.asp)) determines the lowest interest that one may charge on loans below a specific interest rate threshold and considers the amount of potential income generated from the interest rate as imputed income. Because of the creation of AFR, the IRS may collect tax revenue from loans that are otherwise untaxed.

Because imputed tax rates are tied to the actual interest rate environment at a given time, each month, the IRS provides various prescribed rates for federal income tax purposes. AFR rates are regularly published as revenue rulings and can be looked up on the IRS website.

## How to Calculate Imputed Interest on Zero-Coupon Bonds

When calculating imputed interest on a [zero-coupon bond](https://www.investopedia.com/terms/z/zero-couponbond.asp), an investor first determines the bond’s [yield to maturity](https://www.investopedia.com/terms/y/yieldtomaturity.asp) (YTM). Assuming the accrual period is one year, the investor divides the face value of the bond by the price paid when it was purchased. The investor then increases the value by a power equal to one divided by the number of accrual periods before the bond matures. The investor reduces the number by one and multiplies by the number of accrual periods in one year to determine the zero-coupon bond’s YTM.

Because the adjusted purchase price of a zero-coupon bond is initially equal to its purchase price when issued, the accrued interest gained over each accrual period adds to the adjusted purchase price. The accrued interest is the initial adjusted purchase price multiplied by the YTM. This value is the imputed interest for the period.

> **Fast Fact**
>
> While the concept of interest and the charging of interest on loans is a common practice in the financial world, the idea of imputed interest is a legal construct that is used to determine whether a lender is required to pay taxes on a loan that has been made at a below-market interest rate. Imputed interest is, therefore, not an actual interest rate or a real cost to the borrower, but rather a theoretical interest rate that is used for tax purposes.

## Exemptions From Imputed Interest Rules

Several exemptions to imputed interest rules may allow a lender to avoid taxes on the difference between actual and imputed interest rates. For example, a loan between family members may be exempt from imputed interest if the loan is for a reasonable amount (typically less than $10,000) and is charged at a rate that is not significantly below the market rate, and if the loan is not used to purchase income-generating assets. Additionally, loans made by a qualified charitable organization, a political organization, or a nonprofit organization may also be exempt from imputed interest.

Loans made for the purpose of buying a primary residence may be exempt from imputed interest, as may loans made for the purpose of buying a car or other certain other personal property. Additionally, loans made for the purpose of funding a business or investment may also be exempt from imputed interest in some cases.

It's important to note that the rules and exemptions for imputed interest can vary depending on the specific circumstances of the loan and the applicable tax laws. It's always best to consult with a tax professional if you have questions about imputed interest and how it may apply to you.  

## Exploring Imputed Interest in Zero-Coupon Bonds

A [zero-coupon bond](https://www.investopedia.com/terms/z/zero-couponbond.asp) is a type of bond that does not pay periodic interest payments to the bondholder. Instead, the bond is [sold at a discount](https://www.investopedia.com/terms/d/discountbond.asp) from its face value, and the difference between the purchase price and the face value is considered to be the return on the investment. In the case of a zero-coupon bond, the imputed interest is the difference between the purchase price of the bond and the face value. For example, if a zero-coupon bond has a [face value](https://www.investopedia.com/terms/f/facevalue.asp) of $1,000 and is purchased for $700, the imputed interest would be $300.

The bondholder must pay taxes on this imputed interest yearly, even without receiving actual interest payments.  

## Example of Imputed Interest

Imputed interest is important for determining pension payouts. For example, when an employee retires from a company where they were a member of a pension plan, the company may offer the retiree a lump sum of the $500,000 set aside for them under the plan, or they may receive $5,000 a year in benefits. Assuming the applicable short-term federal rate is 2 percent, the retiree needs to determine whether they could find better imputed interest in another market by taking the lump sum and purchasing a higher-yield annuity.

## Can You Deduct Imputed Interest on Your Taxes?

In most cases, imputed interest is not tax-deductible. This means that if you are required to pay taxes on the imputed interest on a loan, you cannot claim a deduction for that interest on your tax return. However, there are some exceptions to this rule. For example, if you use the loan proceeds to buy a primary residence or to fund a business or investment, you may be able to claim a deduction for the imputed interest on your taxes. Additionally, if you are a qualified charitable organization, a political organization, or a nonprofit organization, you may be exempt from the rules on imputed interest and may be able to claim a deduction for the interest you pay on your loans. It's always best to consult with a tax professional if you have questions about whether you can claim a deduction for imputed interest on your taxes.

## Who Pays Imputed Interest?

In most cases, the lender is responsible for paying taxes on the imputed interest on a loan. This means that if the IRS determines that a loan should have been made at a higher interest rate than the actual rate charged by the lender, the lender may be required to pay taxes on the difference between the two rates and is responsible for reporting the imputed interest on their tax return. In some cases, the borrower may also be required to report the imputed interest and pay taxes on it, depending on the specific circumstances of the loan.

## How Do You Compute Imputed Interest?

Several exemptions to imputed interest rules may allow a lender to avoid taxes on the difference between actual and imputed interest rates. In general, however, the imputed interest on a loan is the difference between the actual interest rate charged by the lender and the market interest rate for a similar loan. This difference is then multiplied by the loan principal to determine the amount of imputed interest.

For example, if a borrower receives a loan of $10,000 at an interest rate of 3%, and the market interest rate for a similar loan is actually 4%, the imputed interest would be $100 (1% x $10,000).

## The Bottom Line

Imputed interest refers to the IRS's assessment of interest on loans where little or no interest is charged, typically due to personal arrangements. This concept ensures that low or zero-interest loans are taxed based on a rate that aligns with market conditions. Lenders often pay taxes on the difference between the market rate and the actual rate charged, though some loans, such as small family loans or those for purchasing a primary residence, may be exempt. Understanding and calculating imputed interest is crucial for complying with tax laws and avoiding unintended tax liabilities. Always consult a tax professional to navigate these rules effectively.

**_Correction—May 14, 2023:_** An earlier version of this article incorrectly stated that it is the lender's responsibility to pay interest on a loan. In most cases, lenders are responsible for paying taxes on the imputed interest of a loan.

> **Article Sources**
>
> 1.  TurboTax. "[IRS Tax Rules for Imputed Interest](https://turbotax.intuit.com/tax-tips/tax-payments/irs-tax-rules-for-imputed-interest/L7UbulHpC#:~:text=under%20a%20contract-,Key%20exceptions%20to%20the%20rules,to%20buy%20income%2Dproducing%20assets.)."
>     
> 2.  Internal Revenue Service. "[Applicable Federal Rates (AFRs) Rulings](https://www.irs.gov/applicable-federal-rates)."
>     
> 3.  Intuit. "[IRS Tax Rules for Imputed Income](https://turbotax.intuit.com/tax-tips/tax-payments/irs-tax-rules-for-imputed-interest/L7UbulHpC)."