Question

Under the imputed interest rules, the taxpayer who makes a below-market loan may be required to recognize income he or she did not actually receive. For example, assume that Christian loans $200,000 to Mia, his daughter, to start a business (income-producing property). Christian does not charge interest because Mia needs the funds to operate a struggling startup business. Why should Christian be required to pay tax on a “made-up” number (i.e., the interest he did not charge)? This type of income is sometimes referred to as “phantom” income.

Answer 1

Imputed Interest :

This is the interest that is assumed to be received by the lendor from loans given as interest free or at a lower rate of interest than the rates mentioned in Applicable Federal Rates (AFR's)

These loan transactions generally take place between family, friends and close people. Loan is given by lendor at a lower rate to borrower and he will receive less interest when compared to market rate or nil interest. In this case, we assume that the lendor receives interest at the rates mentioned in AFR (changes monthly) and taxed accordingly.

This is done to avoid tax escaping. If not from this closely related lendor, the borrower may get loan from any outside party who will lend to borrower at market rate. The outside party will then pay tax on the interest earned by him to the federal government, but in the case of closely related parties there may be nil or low level of interest causing the tax loss to federal government. Hence the provision of Imputed interest is brought.

In the given case, Christian loans $200,000 to Mia (his Daughter) to start a business without any interest. As discussed above, this transaction will lead to imputed interest in the hands of Christian and he has to pay tax on such imputed interest.

Note :

1. These type of loans are also called as Gift loans

2. Gift loans under $10,000 are free of imputed interest clause. But here the loan amount exceeded the threshold limit