What is the tax treatment for interest on below-market loans?

Interest on below-market loans is treated as ordinary interest income for tax purposes. This type of loan occurs when the interest charged is significantly lower than the market rate. The Internal Revenue Service (IRS) requires that the lender recognize interest income based on the applicable federal rate (AFR), which is essentially the minimum interest rate that the IRS accepts for tax purposes.

If the interest charged is less than the AFR, the IRS imputed interest to the lender, meaning that the lender must report interest income as if the borrower had paid interest at the AFR. This imputed interest is taxed as ordinary income, reflecting the way that typical interest income from loans is taxed.

This treatment ensures that borrowers cannot escape taxation by lending or borrowing at below-market rates. The intention is to prevent any tax avoidance that could arise from artificially low interest rates, ensuring that all lending activities are treated consistently in terms of income recognition and taxation.