Have you ever loaned money to a friend or family member? And not the 20 or 50 dollars until Friday, but rather several thousand dollars that was used to purchase a home, a car, or even start a business. If you did, you most likely did not charge interest since the loan was simply for the principle and you expect to be paid back at a particular time or over a set period. If you did this and the news of the loan somehow reaches the eyes of the IRS; you as the loaning party could be in for a huge and unpleasant surprise in the form of interest penalties invoked by the imputed interest rule.
What is the imputed interest rule?
In a basic sense, the rule states that in any case of a loan between two private parties, there has to be an interest amount paid to the lender. If there is not a set interest rate between the two parties, the IRS will invoke an interest rate of it's own and tax the lender based on that rate. While the rule seems unfair on paper towards the lender, the cause for this may be the fact that the person receiving the money may be drawing interest on it through a bank or even claiming the loan payments on their tax return and thus cheating the system. It also ensures that money is simply not being laundered through no-interest loans through illegal means or purposes.
How do you solve this problem?
The easiest way to solve this issue is to set an interest rate that is very small and thus satisfying the demand for an interest rate put in place by the imputed interest rule. Yes, you will still pay a tax on the interest received but the amount will be minuscule in comparison with what the IRS would set in place. While it may also seem simply easier to claim the money is a gift you gave, this poses another problem that does not involve the IRS but can be far worse. If you loan money to someone but legally claim the money as a gift, there is nothing legally to keep the other party from deciding not to repay the money. In this case, any legal attempt to satisfy the loan will not be heard. The best way to satisfy the rule is to abide by it and simply set an interest amount that is agreeable to both parties. This will also satisfy the government's demand that interest be paid and collected on the loan so it can be properly taxed.