When you are either giving a loan or receiving a loan, you might notice that it normally carries an interest rate. This interest rate is significant because it will determine how much extra money you will have to pay in addition to the original loan amount. If you are the person giving the loan, it means how much extra you will be receiving in addition to the original loan amount. Given the complexity of interest rates, it is important to understand how they work.
What Are Minimum Interest Rates?
Minimum interest rules require that a minimum rate of interest be charged on any loan transaction between two individuals. The minimum interest rules state that even if the lender charges no rate, an arbitrary rate will be automatically imposed upon the loan. This is done in order to prevent excess gifting among individuals, especially family members. The person giving the loan is called the lender, while the person receiving the loan is called the borrower. However, if the purpose of the loan is for the sake of giving a gift, the person receiving the loan is called the donee and the person giving the loan is called the donor.
How Are Minimum Interest Rates Affected by the Internal Revenue Service?
The Internal Revenue Service (IRS) is an administrative agency under the Department of the Treasury that is responsible for enforcing the Internal Revenue Code (IRC), the set of laws that affect federal taxation across the country. Given that the IRS enforces the IRC, they are also in charge of determining the applicable minimum interest rates for every month of every taxable year. For example, in January of 2023, the Applicable Federal Rates (AFR) for short-term loans were as low as 4.41% monthly. This rate decreased as low as 4.38% in February of 2023 and rose again to 4.41% in March of 2023.
These rates are set monthly by the IRS. For term loans, the rate that should be applied is the federal rate that was set on the day the loan was made. For loans that have a term that is less than three years, the short-term rate would apply. Mid-term rates would apply on loans with terms of three to nine years. For loans with greater than a nine-year term, the long-term rate would apply.
What is Internal Revenue Code Section 7872 and How Does it Affect Minimum Interest Rates?
IRC Section 7872 provides for exceptions to direct gift loans between individuals if the amount is below $10,000. However, this exception does not apply to gift loans made in exchange for profitable assets. For example, if you exchange a $5,000 loan for stock in an ABC Corporation, this exception will most likely not apply. Gift loans up to $100,000 might also qualify as an exception if the loan is granted to a relative or child to buy a home or launch a business. For this to apply, the borrower’s net investment income must be $1,000 or less for the year.
There are similar rules when it comes to total outstanding balances in gift loans. If the total outstanding balance in gift loans exceeds the limits during the year, then the loan will be subject to interest rules. If the net investment income of the borrower exceeds the $1,000 threshold, imputed interest rules would apply but only on their net investment income.
Providing funds could be classified as a loan that may fall within interest rules if granted to senior continuing care facilities as part of the fees paid for ongoing care and if it exceeds certain limits and is considered refundable.
What Happens If I Do Not Follow the Minimum Interest Rates Rules?
Lenders can face tax penalties from the IRS if they do not follow minimum interest rules, even if the borrower is a close family member. Lenders can be charged tax on the amount of interest the IRS believes they should have collected on a loan, even if they did not collect any interest. The amount of any unpaid interest on a loan could also be counted towards a taxpayer’s annual gift limit, leading to double taxation on the money.
