TCP CPA Practice Questions Explained: Calculating Imputed Interest

Calculating Imputed Interest

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In this video, we walk through 5 TCP practice questions about calculating imputed interest on below-market-rate loans. These questions are from TCP content area 1 on the AICPA CPA exam blueprints: Tax Compliance and Planning for Individuals and Personal Financial Planning.

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Calculating Imputed Interest on Below-Market-Rate Loans

Imputed interest is a concept used by tax authorities to ensure that loans made at below-market interest rates are taxed appropriately. It arises when a loan is issued at an interest rate below the applicable federal rate (AFR), which the IRS updates monthly to reflect the current lending environment. The IRS treats these loans as if they had been made at the AFR, and the difference in interest is taxed accordingly.

How It Affects the Gross Income of Lenders:

For the lender, the imputed interest is considered taxable income. This means that even though the lender is not receiving interest payments at the AFR, they must report as income the interest that would have been received if the loan were made at the AFR.

Key Points:

  • Imputed interest does not affect the borrower’s taxable income. The borrower does not need to include any imputed interest in their income calculations. However, the borrower may be able to deduct this interest if the loan qualifies for interest deduction, such as a mortgage.
  • The tax applies to the lender, who must report the imputed interest as if it were actual income received.

Calculating Imputed Interest:

  1. Determine the amount loaned and the interest rate applied.
  2. Identify the applicable federal rate (AFR) at the time the loan was made.
  3. Calculate the interest that would have been paid at the AFR on the principal amount.
  4. Subtract the actual interest paid from the interest calculated at the AFR.
  5. Report the result as income on the lender’s tax return.

Example 1:

Alice lends Bob $10,000 at 1% interest per annum in a year when the AFR is 3%.

  • Principal = $10,000
  • AFR = 3%
  • Actual interest rate = 1%
  • Actual interest = 1% of $10,000 = $100
  • Interest at AFR = 3% of $10,000 = $300
  • Imputed interest = $300 – $100 = $200

Outcome: Alice must include $200 as income on her tax return.

Example 2:

Dan lends Emily $50,000 to help her start a business. The loan is interest-free and the AFR is 4%.

  • Principal = $50,000
  • AFR = 4%
  • Actual interest = $0 (interest-free loan)
  • Interest at AFR = 4% of $50,000 = $2,000

Outcome: Dan must include $2,000 as income on his tax return.


Imputed interest rules ensure that lenders cannot circumvent income tax responsibilities by offering loans at significantly below-market rates. For lenders, understanding these rules is crucial to comply with IRS requirements and to accurately report income. Borrowers, while not taxed on imputed interest, should be aware of potential deductions related to such interest payments.

Exemptions for Small Loans:

  • Loans that are less than a certain amount (currently $10,000) are generally exempt from the imputed interest rules if they are used for personal purposes. This exemption is intended to simplify tax compliance and avoid unnecessary administrative burdens for small, informal loans that are not used for investment or income-producing purposes.
  • Purpose of the Loan: The exemption applies only if the loan is not directly used to purchase income-producing assets. If the borrower uses the loan to invest in income-generating activities, the exemption does not apply, and imputed interest rules would be in effect regardless of the loan amount.


Sarah lends her friend John $9,000 at 0% interest to help him cover medical expenses.

  • Principal = $9,000
  • Interest rate = 0%
  • Applicable federal rate (AFR) = 3%

Outcome: Despite the AFR, since the loan amount is under $10,000 and is used for personal, non-income-producing purposes (medical expenses), no imputed interest needs to be calculated or reported by Sarah.

How This Affects Tax Reporting:

For lenders, knowing this exemption can prevent unnecessary reporting of imputed income on small, personal loans, which simplifies their tax preparation. For borrowers, understanding that these small personal loans do not lead to additional income reporting requirements or tax burdens can ease the process of borrowing from friends or family for non-commercial needs.

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