Imputed Interest: Definition, Calculation, and Key Tax FAQs

Imputed interest is the interest the IRS treats as having been paid or received when a loan carries no interest or a below-market interest rate. It’s a tax construct the IRS uses to prevent untaxed transfers of income through interest-free or low-interest loans, commonly seen in family lending and deeply discounted bonds.

How imputed interest works

When a loan is made with no interest or a rate below market, the IRS may treat the difference between a market rate and the actual rate as imputed interest and tax it as income to the lender.
The IRS distinguishes between actual loans (typically evidenced by a written agreement), demand loans, and gifts. Written records help establish that a transaction is a bona fide loan rather than a gift.
Imputed interest is not a cash payment the borrower necessarily makes; it is a notional amount used for tax reporting.

Fast fact: Imputed interest is a legal construct for tax purposes — it’s not an actual additional cost to the borrower but a theoretical interest amount the IRS uses to determine taxable income.

Applicable Federal Rates (AFRs)

The IRS publishes Applicable Federal Rates (AFRs) monthly. AFRs represent minimum acceptable interest rates for different loan terms and are used to compute imputed interest.
AFRs were established to capture tax revenue from otherwise untaxed low- or no-interest loans. They are available on the IRS website and change with market conditions.

Basic calculation

For a simple stated-rate comparison: Imputed interest ≈ (AFR − actual interest rate) × principal.
Example: A $10,000 loan at 3% when the market rate (AFR) is 4% generates imputed interest of about $100 per year (1% × $10,000).
Who reports: Generally the lender reports the imputed interest as taxable interest income. In some situations, the borrower may have reporting responsibilities; circumstances vary, so consult a tax professional.

Zero-coupon bonds and imputed interest

Zero-coupon bonds pay no periodic interest and are sold at a discount to face value. The difference between purchase price and face value is treated as interest income over the life of the bond.
Yield-to-maturity (YTM) calculation (for annual accrual): YTM = (Face Value / Purchase Price)^(1 / years to maturity) − 1. The imputed interest for each accrual period is the adjusted purchase price × YTM; the adjusted basis is increased each period by that imputed interest.
Even without cash interest payments, bondholders must recognize and pay tax on the imputed interest annually (or under the appropriate tax rules for original issue discount).

Common exemptions and special cases

Small family loans: Loans between family members under $10,000 are often exempt from imputed interest rules if the funds are not used to purchase income-producing assets.
Certain organizations: Loans made by qualified charitable organizations, political organizations, or some nonprofits may be exempt.
Other loan purposes: Some loans for personal use (e.g., primary residence, car, or certain personal property) are sometimes treated differently; rules depend on the exact circumstances.
Exemptions and applications vary by situation — always verify with current tax guidance or a professional.

Can imputed interest be deducted?

In most cases, imputed interest is not deductible. Exceptions may apply if the loan proceeds are used for deductible purposes (for example, certain business or investment uses) or where specific tax rules provide allowances. Check with a tax advisor for your situation.

Example scenarios

Family loan: A parent lends $50,000 to a child at 0% interest. If the AFR is 2%, the IRS will impute $1,000 of interest per year (2% × $50,000), which the parent would generally report as interest income.
Zero-coupon bond: Buy at $700 with a $1,000 face value maturing in one year. Imputed interest for the year is $300 and is taxable even though no cash interest was received.

Key takeaways

Imputed interest is the IRS’s method of taxing below-market or interest-free loans by imputing a market-level interest amount.
AFRs determine the rates used to compute imputed interest and are updated monthly.
Small family loans and certain organizational loans may qualify for exemptions, but rules are specific and situation-dependent.
Lenders typically report and pay tax on imputed interest; zero-coupon bondholders must recognize imputed interest annually.
Because rules and exemptions can be complex, consult a tax professional to ensure correct reporting and compliance.