What It Is:
Imputed Interest refers to interest that is considered by the IRS to have been paid for tax purposes, even if no interest payment was made. The IRS uses imputed interest as a tool to collect tax revenues on loans that don't pay interest, or stated interest is very low.
How It Works/Example:
Imputed interest often becomes an issue when loans are made among family and/or friends. For example, a couple loans their son $100,000 interest free. Assume the applicable short term federal rate is 2%. The amount of interest the son should be paying his parents would be $100,000 X .02 = $2,000.
The IRS would then make an assumption that the annual interest charge the parents should have collected from the son would be $2,000. The IRS would then expect this amount to be listed on the parents' tax return as interest income even though they never received a penny, hence imputed.
The IRS also requires imputed interest to be paid on certain bonds that don't pay interest. Zero-coupon bonds, for example, are sold at a discount to face value and don't pay interest to the holder. The IRS still requires bondholders to report an imputed annual interest.
Why It Matters:
The IRS noticed that many low-term or zero interest loans made to various close parties were not being taxed. The IRS determined that the potential interest generated by these loans was imputed income, which enabled the IRS to collect the potential tax revenue to which they felt entitled.
The IRS instituted Applicable Federal Rates (AFR) with the Tax Act of 1984 to capture taxes on interest income that would otherwise have been lost due to interest free loans that had been agreed upon between closely related parties. The AFR mandates a minimum interest rate for any loan made below a certain interest rate threshold.