Definition: Imputed interest is a concept leveraged by the Internal Revenue Service (IRS) to determine the amount of interest that should be reported for tax purposes. This concept is also important to discounted bonds without a stated interest rate and other securities that mature at their par value but are sold for less than their face value. Since no interest rate is stated on these instruments, one has to be computed.
What Does Imputed Interest Mean?
What is the definition of imputed interest? This concept basically applies to all financial instruments, such as a loan, that have favorable interest terms that may generate unrealistic tax implications. Instruments such as loans from family or friends, or discounted bonds that are purchased below face value, all can generate a requirement to impute the interest to the IRS.
Simply put, if you have something like a loan from a friend, and you’re not required to pay them interest, odds are your friend will have to report interest income based on an imputed rate designated by the IRS. The IRS publishes the imputed tax rates each month. In theory, this interest levels the playing field from a tax perspective, and it helps alleviate the incentives to exploit taxable income.
This concept applies to financial instruments with favorable interest rates that do not meet the minimum federal guidelines as outlined by the IRS.
Let’s take a look at an example.
To present a good example of this concept, let’s expand on the concept of a loan that you received from your friends. In an effort assist you with your first home purchase, your friends have agreed to give you a $30,000 interest free loan. To ensure the loan isn’t a burden on your cash situation after moving into your first home, your friends agreed to a term of 10 years, and you have the option to pay down the principle balance when you’re able to do so (as long as it’s all paid back by the end of the 10th year).
This sounds great! Now, let’s think about how this impacts your friends taxable income. The fact that your friends would provide you a loan, while reporting no interest income, is not reasonable from a taxable income perspective because they would collect an interest payment from anyone else they loaned money to.
Your friends will have to calculate a made up amount of interest income to report as if they actually received the interest. In our example, let’s assume the federal rate is 1.5 percent. This should be applied to the outstanding principle balance. Assuming you make no payments in year 1, and the principle balance is still $30,000, your friends would have to report $450 of taxable interest income ($30,000 x 1.5%).
Define Imputed Interest: a requirement to report interest based on a federal rate assigned by the IRS.