Imputed InterestDefined with Examples & More

Written By:
Adiste Mae

What is Imputed Interest?

The estimated interest rates on debts are called Imputed Interest.

It is also the interest used by the Internal Revenue Service (IRS) to collect taxes on debt securities that pay minimal interest, or no interest at all, usually to family members or personal and business loans.

When it comes to bonds (discount bonds such as zero-coupon bonds) and below market loans, the use of Imputed Interest is significant.

When it comes to zero coupon bonds, the imputed interest is based on the minimum interest rate, while the accrued interest based on the yield to maturity is used for below market loans.

When the IRS computes for the imputed interest on Treasury Bonds, an accretive method is employed and has set federal tax rates at a minimum interest rate relating to imputed interest and original issue discount rules.

Understanding Imputed Interest

Regardless of whether or not a lender actually receives interest income on the money lent, an imputed interest is computed.

The minimum interest rate on a short-term loan is 2%.

So if a person lends another an amount of $20,000 and collects no interest, the IRS will still assume that the person who lent the money has collected interest on the amount borrowed regardless of whether or not an interest income has actually been received.

Upon submission of the tax return, the lender will have to list interest income in the amount of $400.

Applicable Federal Rates

The provision for Applicable Federal Rates (AFR) is set by the Tax Reform Act of 1984 and details the minimum tax rates that must be charged on all types of loans, including personal loans.

The reason for the IRS setting the AFR was due to the many loans that were not taxed, particularly interest-free and low-interest loans.

Each month, the IRS publishes the Index of AFR Rulings online to keep up with the economy.

If a lender lends money and charges interest rate below the AFR, the IRS will impute the interest on the lender as if they have received an interest income.

Lenders will also be expected to report the imputed interest in their income tax return as a taxable interest income.

Since the AFR has been created, the IRS has been able to collect the revenue that they were not able to collect before from loans that went untaxed.

Calculating Imputed Interest on a Zero-Coupon Bond

It is important to compute the imputed interest on a zero-coupon bond because interest is not earned for the duration of the bond – it is earned only at maturity.

Where lenders make money from zero-coupon bonds is through its sale at a discount to the face value.

Over time, the value of the bond increases due to the accrued interest earned until it reaches face value at maturity.

Taxpayers are required to declare the imputed interest on zero-coupon bonds.

To compute its imputed interest, the first step is to compute the bond’s Yield to Maturity.

The formula is:

YTM = [(FV / PV)1 / (nt) – 1] x n

Where:

FV = Future Value

PV = Present Value

n = Number of accruing periods per year

t = Number of years left

Once the Yield to Maturity (YTM) is computed, the imputed interest on the zero-coupon bond can be computed next. Its formula is:

Imputed Interest on Zero-Coupon Bond = YTM x PV

An Example of Imputed Interest

Most of the imputed interest is earned from loans between families, friends or colleagues.

For example, a mother lends her daughter $30,000 to start her own business which she has promised to pay in equal installments for a period of 3 years.

But because she’s family, the mother does not charge her any interest on the amount borrowed.

When the mother prepares her tax return, the IRS will expect her to report the imputed interest earned on the loan despite her not receiving any interest income from her daughter.

Assuming that the interest rate set by the IRS for short-term loans is 1%, the interest income to be reported by the mother annually is $300 ($300,000 x 1%).