If you receive a below-market gift or demand loan and use the proceeds in your trade or business, you may be able to deduct the forgone interest. See Treatment of gift and demand loans later in this discussion.
A below-market loan is a loan on which no interest is charged or on which interest is charged at a rate below the applicable federal rate. A gift or demand loan that is a below-market loan generally is considered an arm's-length transaction in which you, the borrower, are considered as having received both the following.
- A loan in exchange for a note that requires the payment of interest at the applicable federal rate.
- An additional payment in an amount equal to the forgone interest.
The additional payment is treated as a gift, dividend, contribution to capital, payment of compensation, or other payment, depending on the substance of the transaction.
For any period, forgone interest is:
- The interest that would be payable for that period if interest accrued on the loan at the applicable federal rate and was payable annually on December 31,
- Any interest actually payable on the loan for the period.
Applicable federal rates are published by the IRS each month in the Internal Revenue Bulletin. Internal Revenue Bulletins are available on the IRS web site at www.irs.gov/irb
. You can also contact an IRS office to get these rates.
The rules for below-market loans apply to the following.
- Gift loans (below-market loans where the forgone interest is in the nature of a gift).
- Compensation-related loans (below-market loans between an employer and an employee or between an independent contractor and a person for whom the contractor provides services).
- Corporation-shareholder loans.
- Tax avoidance loans (below-market loans where the avoidance of federal tax is one of the main purposes of the interest arrangement).
- Loans to qualified continuing care facilities under a continuing care contract (made after October 11, 1985).
Except as noted in (5) above, these rules apply to demand loans (loans payable in full at any time upon the lender's demand) outstanding after June 6, 1984, and to term loans (loans that are not demand loans) made after that date. taxmap/pubs/p535-017.htm#en_us_publink1000153641
If you receive a below-market gift loan or demand loan, you are treated as receiving an additional payment (as a gift, dividend, etc.) equal to the forgone interest on the loan. You are then treated as transferring this amount back to the lender as interest. These transfers are considered to occur annually, generally on December 31. If you use the loan proceeds in your trade or business, you can deduct the forgone interest each year as a business interest expense. The lender must report it as interest income. taxmap/pubs/p535-017.htm#en_us_publink1000153642
For gift loans between individuals, forgone interest treated as transferred back to the lender is limited to the borrower's net investment income for the year. This limit applies if the outstanding loans between the lender and borrower total $100,000 or less. If the borrower's net investment income is $1,000 or less, it is treated as zero. This limit does not apply to a loan if the avoidance of any federal tax is one of the main purposes of the interest arrangement. taxmap/pubs/p535-017.htm#en_us_publink1000153643
If you receive a below-market term loan other than a gift or demand loan, you are treated as receiving an additional cash payment (as a dividend, etc.) on the date the loan is made. This payment is equal to the loan amount minus the present value, at the applicable federal rate, of all payments due under the loan. The same amount is treated as original issue discount on the loan. See Original issue discount (OID) under Interest You Can Deduct, earlier. taxmap/pubs/p535-017.htm#en_us_publink1000153644
The rules for below-market loans do not apply to any day on which the total outstanding loans between the borrower and lender is $10,000 or less. This exception applies only to the following.
- Gift loans between individuals if the loan is not directly used to buy or carry income-producing assets.
- Compensation-related loans or corporation-shareholder loans if the avoidance of any federal tax is not a principal purpose of the interest arrangement.
This exception does not apply to a term loan described in (2) above that was previously subject to the below-market loan rules. Those rules will continue to apply even if the outstanding balance is reduced to $10,000 or less.
The following loans are specifically exempted from the rules for below-market loans because their interest arrangements do not have a significant effect on the federal tax liability of the borrower or the lender.
- Loans made available by lenders to the general public on the same terms and conditions that are consistent with the lender's customary business practices.
- Loans subsidized by a federal, state, or municipal government that are made available under a program of general application to the public.
- Certain employee-relocation loans.
- Certain loans to or from a foreign person, unless the interest income would be effectively connected with the conduct of a U.S. trade or business and not exempt from U.S. tax under an income tax treaty.
- Any other loan if the taxpayer can show that the interest arrangement has no significant effect on the federal tax liability of the lender or the borrower. Whether an interest arrangement has a significant effect on the federal tax liability of the lender or the borrower will be determined by all the facts and circumstances. Consider all the following factors.
- Whether items of income and deduction generated by the loan offset each other.
- The amount of the items.
- The cost of complying with the below-market loan provisions if they were to apply.
- Any reasons, other than taxes, for structuring the transaction as a below-market loan.
The below-market interest rules do not apply to a loan owed by a qualified continuing care facility under a continuing care contract if the lender or lender's spouse is age 62 or older by the end of the calendar year.
A qualified continuing care facility is one or more facilities (excluding nursing homes) meeting the requirements listed below.
- Designed to provide services under continuing care contracts (defined below).
- Includes an independent living unit, and either an assisted living or nursing facility, or both.
- Substantially all of the independent living unit residents are covered by continuing care contracts.
A continuing care contract is a written contract between an individual and a qualified continuing care facility that includes all of the following conditions.
- The individual or individual's spouse must be entitled to use the facility for the rest of their life or lives.
- The individual or individual's spouse will be provided with housing, as appropriate for the health of the individual or individual's spouse in an:
- independent living unit (which has additional available facilities outside the unit for the provision of meals and other personal care), and
- assisted living or nursing facility available in the continuing care facility.
- The individual or individual's spouse will be provided with assisted living or nursing care available in the continuing care facility, as required for the health of the individual or the individual's spouse.
For more information, see section 7872(h) of the Internal Revenue Code.taxmap/pubs/p535-017.htm#en_us_publink1000153647
Different rules generally apply to a loan connected with the sale or exchange of property. If the loan does not provide adequate stated interest, part of the principal payment may be considered interest. However, there are exceptions that may require you to apply the below-market interest rate rules to these loans. See Unstated Interest and Original Issue Discount (OID) in Publication 537.taxmap/pubs/p535-017.htm#en_us_publink1000153648
For more information on below-market loans, see section 7872 of the Internal Revenue Code and section 1.7872-5 of the regulations.