Unstated Interest Paid

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Unstated Interest Paid

What it is

Unstated interest paid is the amount of interest the IRS assumes has been charged on an installment sale when the written contract either does not state an interest rate or states a rate below the applicable federal rate (AFR). The IRS imputes that interest so that part of each installment payment is treated as interest income and the remainder as principal (sale proceeds).

How it works

  • The IRS requires interest to be recognized on installment sales that extend over time.
  • If a contract lacks a stated interest rate or the stated rate is lower than the AFR for the term, the IRS imputes interest using the AFR.
  • Seller must allocate each installment between interest (taxed as ordinary income) and principal (subject to capital gains rules as applicable).

Applicable Federal Rates (AFRs)

The IRS publishes AFRs monthly. Choose the AFR based on the contract’s term:
– Short-term: maturities of three years or less.
– Mid-term: maturities over three years and up to nine years.
– Long-term: maturities over nine (generally ten) years.

Use the AFR that matches each deferred payment’s effective maturity when computing imputed interest.

How to calculate unstated interest

  1. Determine each installment’s principal amount and its maturity (time until payment) in years.
  2. Select the appropriate AFR for that maturity.
  3. For each installment, compute interest ≈ principal × AFR × time (in years).
  4. Sum the interest amounts across installments — this is the unstated interest the IRS will impute.
  5. Allocate each payment between interest (taxable as ordinary income) and principal (reduces basis for capital-gains reporting or is treated as sale proceeds).

Note: For more complex contracts or varying payment schedules, use present-value methods consistent with IRS guidance or consult a tax professional.

Example

Preeti sells furniture for $10,000 with two payments: $5,000 in six months and $5,000 in one year. The contract states no interest. If the AFR is 2% per year:
– Interest on $5,000 for 0.5 years = $5,000 × 0.02 × 0.5 = $50
– Interest on $5,000 for 1 year = $5,000 × 0.02 × 1 = $100
– Total unstated interest = $150

The IRS would treat $150 as interest income and $9,850 ($10,000 − $150) as the sale proceeds allocated to principal.

Tax consequences

  • Imputed interest is taxable to the seller as ordinary income when earned or when payments are received, depending on the method used.
  • Principal payments are treated as part of the sale and affect gain recognition and basis recovery.
  • If a stated interest rate equals or exceeds the AFR, no unstated interest is imputed. If it is below the AFR, the difference is imputed as interest.

FAQs

Bottom line

When you sell property on an installment basis with little or no stated interest, the IRS may impute interest using the applicable federal rates. That imputed (unstated) interest is taxable as interest income and reduces the portion of payments treated as sale proceeds. Use the correct AFR for each payment term and consider professional tax guidance for accurate reporting.

Sources

  • IRS Publication 537, Installment Sales
  • IRS guidance on Applicable Federal Rates (AFRs)
  • Federal Register notices on AFR determinations