Imputed Interest

Imputed interest is interest that an authority treats as charged and received on a loan or a note when the parties stated no interest at all, or a rate below a market rate. No cash moves for it, and it still has to be recognized, as interest income to the lender, as a transfer to the borrower, or as a discount folded into the carrying amount of the note. Two separate bodies of rules do the imputing in a US firm’s work, federal tax law on below-market loans and US GAAP on a note exchanged for property, goods or service at a rate that is not a market rate or on a cash note that carried other rights or privileges with it, and they do not use the same rate.

Section 7872 and Below-Market Loans

A loan is below market in one of two ways. A demand loan is below market when interest is payable on it at a rate less than the applicable federal rate, and a term loan is below market when the amount loaned exceeds the present value of all payments due under the loan, that is, what those future payments are worth today once they are discounted back at the applicable federal rate as of the date of the loan (26 U.S.C. 7872(e)(1), and see section 7872(f)(1) for that discount rate and that date). Forgone interest, the amount actually at issue, is the excess of the interest that would have been payable at the applicable federal rate over any interest actually payable for that period (section 7872(e)(2)).

What happens next depends on the kind of loan. For a gift loan or a demand loan, section 7872(a)(1) treats the forgone interest as transferred from the lender to the borrower and then retransferred by the borrower to the lender as interest, with both legs falling on the last day of the calendar year (section 7872(a)(2)). For any other below-market loan in scope, section 7872(b)(1) treats the lender as having handed the borrower cash on the date the loan was made, equal to the amount loaned less the present value of all payments required under the loan, and section 7872(b)(2)(A) treats that same excess as original issue discount on the note.

The section does not reach every cheap loan. It applies to gift loans, compensation-related loans between an employer and an employee or between an independent contractor and a person for whom that contractor provides services, corporation-shareholder loans, loans where avoidance of federal tax is one of the principal purposes of the interest arrangement, and loans to a qualified continuing care facility under a continuing care contract. A sixth category is residual: to the extent provided in regulations, any other below-market loan whose interest arrangements have a significant effect on any federal tax liability of the lender or the borrower (section 7872(c)(1)).

There Is No Single IRS Imputed Interest Rate

The applicable federal rate is three rates, not one. Section 1274(d)(1)(A) assigns the federal short-term rate to an instrument with a term of not over three years, the federal mid-term rate to a term over three years but not over nine years, and the federal long-term rate to a term over nine years, and during each calendar month the Secretary determines all three for the month that follows (26 U.S.C. 1274(d)).

Which of the three applies is fixed by the statute rather than chosen. For a term loan, section 7872(f)(2)(A) takes the applicable federal rate in effect under section 1274(d) as of the day the loan was made, compounded semiannually. For a demand loan, section 7872(f)(2)(B) takes the federal short-term rate in effect for the period being measured, also compounded semiannually.

Subtopic 835-30 and Notes That State Too Little

Financial reporting imputes interest for a different reason and at a different rate. Where an established exchange price is not determinable and the note has no ready market, an applicable interest rate is approximated which may differ from the stated or coupon rate, and that process of approximation is frequently called imputation (APB Opinion No. 21, paragraph 10). The codified home of the guidance is Subtopic 835-30, Interest, Imputation of Interest (FASB Accounting Standards Update 2015-03).

The trigger is a failed presumption rather than a rate table. When a note is exchanged for property, goods or service in a bargained transaction entered into at arm’s length, the rate the parties stipulated is presumed to be fair and adequate compensation, and that presumption drops away in three cases: interest is not stated, the stated interest rate is unreasonable, or the stated face amount is materially different from the current cash sales price for the same or similar items or from the market value of the note at the date of the transaction (APB Opinion No. 21, paragraph 12).

The present value of a note stipulating no interest or a clearly unreasonable rate is then found by discounting all future payments at an imputed rate. That determination is made when the note is issued, assumed or acquired, and later changes in prevailing rates are ignored (paragraph 12).

A cash loan is treated differently. A note received or issued solely for cash, with no other right or privilege exchanged, is presumed instead to have a present value at issuance measured by the cash proceeds exchanged. Where cash and some other right or privilege are exchanged for the note, the value of that right or privilege is given accounting recognition by establishing a note discount or premium account, and the effective rate then differs from the stated rate (APB Opinion No. 21, paragraphs 7 and 11).

The imputed rate is not the applicable federal rate. It will normally be at least equal to the rate at which the debtor can obtain financing of a similar nature from other sources at the date of the transaction, informed by prevailing rates for similar instruments of issuers with similar credit ratings (APB Opinion No. 21, paragraph 13).

Ordinary trade balances stay out of it. Receivables and payables arising with customers or suppliers in the normal course of business and due in customary trade terms not exceeding approximately one year are outside the guidance (APB Opinion No. 21, paragraph 3), which is the same scope line that keeps a supplier balance out of note accounting in accounts payable and notes payable.

Where the Number Lands in a Firm’s Work

In the close it lands twice, as a discount against the note and then as interest in each period that follows. The interest method that unwinds that discount, and the presentation that keeps it against the face amount rather than beside it, are set out in bonds payable, and the same unwinding under a different name is accretion.

On the return, the lender is the one who reports. For a below-market gift or demand loan the lender must report the forgone interest as interest income, and those transfers are considered to occur annually, generally on December 31 (IRS Publication 550 (2025), Below-Market Loans). For a below-market term loan other than a gift loan, an equal amount is treated as original issue discount and the lender reports the annual part of that discount as interest income. Interest belongs in gross income whether or not an information return ever arrives for it, which is the ground covered in interest income.

A Worked Example

Say a corporation lends a shareholder cash in August 2026 on a note repayable in a single payment three years later, with no stated interest. The term is not over three years, so the federal short-term rate applies, taken as of the day the loan was made and compounded semiannually, which for August 2026 is 4.06% (Rev. Rul. 2026-13, Table 1).

Amount loaned                                    100,000.00
Applicable federal rate, semiannual compounding       4.06%
Semiannual periods                                        6
Present value of the single payment               88,640.60
Excess treated as transferred at the outset       11,359.40

That excess is what section 7872(b)(1) treats the corporation as having handed the shareholder on the day the loan was made, and section 7872(b)(2)(A) turns the same amount into original issue discount on the note, which the lender then picks up in annual parts as interest income.

What Imputed Interest Is Not

A nominal or stated rate is the rate the parties wrote down (nominal interest rate). Accrued interest is interest at a stated rate that has been earned or incurred with the passage of time and has not yet been paid (accrued interest). Imputed interest is neither of those. It is the number an authority substitutes when the parties wrote down nothing, or too little.

Two more get pulled into the same conversation without belonging in it: turning a stated rate into what a year actually produces is a compounding conversion (effective interest rate formula), and adding interest to the cost of an asset instead of running it through expense is a separate decision again (capitalized interest).

Common Questions

Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a block of its own related-party loan and interest workpapers through a trial task before anything client facing depends on it.