How imputed interest works
What is imputed interest?
On a loan that charges less than the IRS minimum rate (the AFR), the IRS "imputes" the missing interest. It acts as if you charged the AFR, then treats the shortfall as a gift from you to the borrower. It applies to loans over $10,000.
Is it a gift every year, or once?
Once, if the loan has a set term. The gift tax counts the whole gift on the day you lend: the amount you lend, less what the payments are worth today at the AFR. A loan with no end date, repaid whenever you ask, is counted year by year instead, on the interest you didn't charge that year. Income tax counts it differently: there, the interest you didn't charge shows up year by year.
Do I actually owe tax on it?
Usually not. The gift counts against the $19,000 annual exclusion in the year you make the loan, along with your other gifts to that person that year. Under it, there's nothing to file. Above it, you file a Form 709 but usually still owe no tax. It draws on your lifetime exemption.
How do I avoid imputed interest entirely?
Charge at least the current AFR for your loan's term. At or above the AFR, there's no forgone interest and no gift.
General information, not tax or legal advice. This assumes level monthly payments starting a month after you lend. A loan with no end date is counted year by year instead. AFRs change every month, so check with the IRS and your CPA.