Definition
A loan charging interest below the IRS's Applicable Federal Rate, triggering imputed interest tax consequences for the lender unless the loan is small enough to qualify for exemptions.
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Below-market loans between family members trigger imputed interest taxation even if parties intend the loan as a gift or family favor. The lender must report imputed interest as income; the borrower might deduct it. Small loans (under $10,000) are exempt from imputed interest rules unless used to purchase income-producing property. There are complex rules for multiple loans and loans in series. Gift loans below $100,000 have simplified imputed interest rules based on the loan balance and foregone interest. Structured properly, below-market loans can transfer wealth (parents loan children money at no interest, children keep earnings above imputed interest), but require understanding tax consequences. Many family loan arrangements fail to account for imputed interest, creating tax issues when audited. Proper documentation (promissory note, AFR-compliant interest, regular payments) prevents problems.
Pro Tip
If lending to family, document it as a proper promissory note with AFR-compliant interest. This prevents surprises and shows legitimate intent to the IRS.
Example
A parent loans a child $100,000 for a down payment at no interest. The AFR is 5%, so the parent reports $5,000 annual imputed interest income, spreading a $50,000 tax transfer over 10 years.