Definition
Interest automatically added by the IRS to below-market loans between related parties or certain other transactions, ensuring income tax consequences even if parties don't charge explicit interest.
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If you loan money to family at no interest or below-market rates, the IRS 'imputes' (assumes) interest and requires you to report it as income. This prevents tax avoidance through interest-free family loans. Imputed interest is calculated using the Applicable Federal Rate (AFR) published monthly by the IRS. If you charge interest below AFR, the difference is imputed. Imputed interest applies to gift loans (even if genuinely made without intent to charge interest), seller financing, and certain other transactions. The borrower can deduct imputed interest (if loan funds are used for business or investment), reducing the tax gift. Imputed interest rules are complex and often ignored by families, creating tax surprises when the IRS notices. Understanding imputed interest is crucial for seller-financed sales, family loans, and related-party transactions. Many people sell property to family with no interest, not realizing they must report imputed interest income annually.
Pro Tip
When making loans to family, charge at least the AFR to avoid imputed interest complications. The AFR changes monthly and is published on the IRS website.
Example
A parent loans $100,000 to their child for a business at no interest. The AFR is 5%, so the parent must report $5,000 annual imputed interest income, and the child can deduct it (if business use).