Imputed Interest

The IRS uses imputed interest to collect tax revenues on loans or securities that pay little or no interest. Imputed interest is important for discount bonds, such as zero-coupon bonds and other securities sold below face value and mature at par. The IRS uses an accretive method when calculating the imputed interest on Treasury bonds and has applicable federal rates that set a minimum interest rate in relation to imputed interest and original issue discount rules.

Imputed interest may apply to loans among family and friends. For example, a mother loans her son $50,000 with no interest charges. The applicable short-term federal rate is 2 percent, so the son should pay his mother $1,000 annually in interest. The IRS assumes the mother collects this amount from her son and lists it on her tax return as interest income even though she did not collect the funds.

Because there were many low-interest or interest-free loans that went untaxed, the IRS established applicable federal rates through the Tax Act of 1984. The AFR determines the lowest interest that one may charge on loans below a specific interest rate threshold and considers the amount of potential income generated from the interest rate as imputed income. Because of the creation of AFR, the IRS may collect tax revenue from loans that otherwise untaxed.

When calculating imputed interest on a zero-coupon bond, an investor first determines the bond’s yield to maturity. Assuming the accrual period is one year, the investor divides the face value of the bond by the price paid when it he or she purchased it. The investor then increases the value by a power equal to one divided by the number of accrual periods before the bond matures. The investor reduces the number by one and multiplies by the number of accrual periods in one year to determine the zero-coupon bond’s YTM.

Because the adjusted purchase price of a zero-coupon bond is initially equal to its purchase price when issued, the accrued interest gained over each accrual period adds to the adjusted purchase price. The accrued interest is the initial adjusted purchase price multiplied by the YTM. This value is the imputed interest for the period.

Imputed interest is important for determining pension payouts. For example, when an employee retires from a company where he or she was a member of a pension plan, the company may offer the retiree a lump sum of the $500,000 set aside for him or her under the plan, or he or she may receive $5,000 a year in benefits. Assuming the applicable short-term federal rate is 2 percent, the retiree needs to determine whether he or she could find a better imputed interest in another market by taking the lump sum and purchasing a higher-yield annuity.