Below market loan

What Is a Below Market Loan?

A below market loan is a loan extended with an interest rate that is lower than the prevailing market rates or, more specifically, lower than a rate prescribed by a regulatory authority. In the context of U.S. taxation, this typically refers to a loan where the interest charged is less than the Applicable Federal Rate (AFR) set monthly by the Internal Revenue Service (IRS). Such loans fall under the broader category of taxation because the IRS may "impute" interest on these transactions, treating the difference between the actual interest charged and the AFR as taxable income for the lender. Below market loans are often found in transactions between related parties, such as family members, employers and employees, or corporations and shareholders.

History and Origin

The concept of imputed interest on below market loans gained significant traction with the enactment of Section 7872 of the Internal Revenue Code in 1984. Before this, individuals could effectively transfer wealth or provide benefits without incurring tax consequences by extending interest-free or low-interest loans. For instance, a high-income individual could lend money to a lower-income family member without charging interest, allowing the family member to earn investment income that would be taxed at a lower rate, and avoiding potential gift tax implications on the foregone interest.

To curb this potential for tax avoidance, Section 7872 was introduced to treat certain below market loans as if interest had been charged at the AFR and then retransferred to the borrower as a gift, compensation, or dividend, depending on the nature of the loan. This legislative change aimed to ensure that economic benefits transferred through such loan arrangements were appropriately recognized for tax purposes. The IRS regularly publishes the Applicable Federal Rates (AFRs), which are minimum interest rates that should be charged on certain loans to avoid imputed interest.¹¹

Key Takeaways

• A below market loan charges an interest rate lower than current market rates or the IRS's Applicable Federal Rate (AFR).
• The IRS may "impute" interest on these loans, taxing the lender on interest that was not actually received.
• Common scenarios for below market loans include loans between family members, employers and employees, or corporations and shareholders.
• Exceptions exist for certain de minimis loan amounts or specific types of loans, such as some student loans.
• Imputed interest rules aim to prevent tax avoidance through interest-free or low-interest lending.

Formula and Calculation

The calculation of imputed interest on a below market loan depends on whether it is a demand loan (payable in full at any time) or a term loan (with a definite repayment schedule). For most below market loans, the imputed interest is the difference between the interest that would have accrued if the loan bore interest at the appropriate AFR and the interest actually paid on the loan.

For demand loans, the imputed interest is generally calculated daily, and the total amount is typically recognized at the end of the calendar year. For term loans, the imputed interest is calculated as the excess of the amount loaned over the present value of all payments due under the loan. This difference is treated as transferred from the lender to the borrower on the date the loan was made.

The imputed interest amount (II) can be broadly understood as:

Where:

• (II) = Imputed Interest
• (Loan Principal) = The initial amount of the debt
• (AFR) = The Applicable Federal Rate relevant to the loan's term (short-term, mid-term, or long-term) and compounding period.
• (Actual Interest Paid) = The interest amount explicitly charged and paid on the loan.

The IRS publishes new AFRs monthly, which are derived from the average yield of U.S. Treasury obligations with similar maturities.¹⁰

Interpreting the Below Market Loan

Interpreting a below market loan primarily involves understanding its tax implications for both the lender and the borrower. From a tax perspective, the IRS essentially recharacterizes a below market loan as a two-part transaction: first, the lender is deemed to have transferred funds to the borrower (e.g., as a gift, compensation, or dividends), and second, the borrower is deemed to have used those funds to pay interest back to the lender at the AFR. This deemed interest is considered taxable income for the lender.⁹

For example, if a parent makes an interest-free loan to a child, the foregone interest (the difference between the AFR and zero) might be considered a taxable gift from the parent to the child, and the parent would also be taxed on that foregone interest as if they had received it. The specific tax treatment varies based on the purpose of the loan (e.g., gift, compensation, corporate-shareholder). It's crucial for individuals and entities engaging in such transactions to understand the AFRs and the potential for imputed interest to avoid unexpected tax liabilities.

Hypothetical Example

Consider Jane, who lends her brother, Tom, $150,000 to help him purchase a home. Jane wants to help Tom, so she offers the loan at 0% interest for a term of 5 years. At the time the loan is made, the applicable mid-term AFR (for loans between 3 and 9 years) is 4.00%.

Under IRS rules, this is a below market loan because the 0% interest rate is less than the 4.00% AFR. The IRS will impute interest to Jane, treating her as if she received 4.00% interest on the loan, even though she received nothing.

For the first year, the imputed interest would be:
$150,000 (Principal) * 0.04 (AFR) = $6,000

Jane would be required to report $6,000 as interest income on her tax return, even though Tom paid her no interest. Additionally, the $6,000 foregone interest might be considered a taxable gift from Jane to Tom, potentially subject to gift tax rules if it exceeds annual exclusion limits. This highlights the importance of structuring related-party loans as an arm's length transaction to avoid unintended tax consequences.

Practical Applications

Below market loans commonly appear in several real-world scenarios, primarily among related parties where explicit interest payments might be avoided or reduced.

• Intra-Family Loans: Parents lending to children for home purchases or education, or other family members assisting each other financially. These loans are subject to AFR rules, and the IRS may impute interest if the rate is too low.⁸
• Employer-Employee Loans: A company might provide a low-interest or interest-free loan to an employee, perhaps for relocation or as a benefit. The foregone interest could be treated as taxable compensation to the employee.
• Corporation-Shareholder Loans: Corporations might lend money to their shareholders at reduced rates, or vice versa. The imputed interest might be treated as a dividend distribution or a capital contributions, depending on the direction of the loan and its purpose.
• Financial Planning: Individuals engaged in financial planning often consider the tax implications of such loans. Proper structuring, including charging at least the AFR, can prevent unexpected tax liabilities for the lender.
• Public Company Disclosures: For public companies, any loans to or from related parties, including below market loans, require specific disclosures in financial statements to meet Securities and Exchange Commission (SEC) requirements. These disclosures ensure transparency for investors regarding transactions that may not be at arm's length.⁷

Limitations and Criticisms

While imputed interest rules for below market loans aim to prevent tax avoidance, they come with certain complexities and can sometimes create unexpected burdens. A primary criticism is the administrative complexity for individuals who engage in simple, informal lending arrangements with family members. Many people might be unaware of the AFR rules, leading to unintentional non-compliance and potential tax issues.

Another limitation is the "de minimis" exception, which exempts certain small loans from imputed interest rules. For example, gift loans between individuals totaling $10,000 or less are generally exempt, provided the funds are not used to purchase income-producing assets. Similarly, certain compensation-related or corporation-shareholder loans under $10,000 can also be exempt if tax avoidance is not a primary purpose.⁶ However, for larger loans, even if the intent is purely benevolent, the tax implications can be significant. The rules may also disproportionately affect those who genuinely wish to provide financial assistance without the complexity of formal loan agreements or the burden of tracking imputed interest.

Below Market Loan vs. Subsidized Loan

While both a below market loan and a subsidized loan offer more favorable terms than prevailing market rates, their fundamental nature and purpose differ significantly, particularly in a consumer context like student loans.

A below market loan typically refers to a private loan, often between related parties, where the interest rate is intentionally set lower than the market rate, primarily for personal, family, or business considerations. The "below market" aspect here carries a tax implication for the lender, who may be subject to imputed interest rules by the IRS. The beneficial rate is due to the relationship between the borrower and the lender, not an external entity.

In contrast, a subsidized loan is a specific type of loan, most commonly seen in federal student aid, where an external entity (like the U.S. Department of Education) pays the interest that accrues on the loan during specific periods, such as when the borrower is in school, during a grace period, or during deferment.⁵ This subsidy is based on the borrower's demonstrated financial need, not the relationship with the original lender. The primary benefit of a subsidized loan is that the loan's principal balance does not grow during these periods because the interest is covered, saving the borrower money over the life of the loan.⁴ Unlike private below market loans, subsidized loans are explicitly designed to assist eligible individuals and do not typically trigger imputed interest taxation for the government entity providing the subsidy.³

FAQs

What is the purpose of the IRS taxing below market loans?

The IRS taxes below market loans to prevent tax avoidance. Without these rules, individuals or entities could transfer wealth or provide benefits without incurring appropriate tax liabilities, such as gift tax or income tax, by simply making interest-free or low-interest loans. The rules ensure that the economic benefit of such a loan is recognized for tax purposes.

Are all below market loans subject to imputed interest?

Not all below market loans are subject to imputed interest. The IRS provides certain exceptions, notably a de minimis rule for gift loans between individuals. Generally, gift loans of $10,000 or less are exempt, provided the funds are not used to purchase income-producing assets. Other exceptions may apply to certain compensation-related or corporation-shareholder loans under specific thresholds.

How does the Applicable Federal Rate (AFR) relate to below market loans?

The Applicable Federal Rate (AFR) is the minimum interest rate the IRS requires to be charged on loans between related parties to avoid imputed interest.² If a loan's interest rate is below the relevant AFR for its term (short-term, mid-term, or long-term), the IRS may "impute" the difference as taxable interest income to the lender. The AFRs are published monthly by the IRS.¹

What are the tax consequences for the borrower of a below market loan?

For the borrower of a below market loan, the tax consequences typically relate to the "deemed" transfer from the lender. Depending on the nature of the loan, this transfer could be considered a gift, compensation, or a dividend. For instance, if an employer provides a below market loan to an employee, the foregone interest could be considered additional compensation and thus taxable income to the employee.

How can one avoid imputed interest on a related-party loan?

To avoid imputed interest on a related-party loan, the lender should charge an interest rate that is at least equal to the Applicable Federal Rate (AFR) for the month and term in which the loan is made. By setting the interest rate at or above the AFR, the loan is treated as an arm's length transaction for tax purposes, and no interest is imputed.