A below-market loan is a loan on which the interest charged is less than the applicable federal rate (AFR). The excess of interest computed using the AFR over the interest actually charged is treated as being transferred by the borrower to the lender as interest and also as being transferred back from the lender to the borrower. The amount and the timing of these deemed transfers dependent upon the type of loan. Deemed transfers are treated for all tax purposes as if actually made.

The deemed transfer from the lender to the borrower is treated as a gift, compensation, dividend, or contribution to capital depending on the relationship between the borrower and the lender. The deemed interest is then treated as transferred back to the lender as interest. These deemed transactions, of course, may have an income tax effect through the creation of income and deductions, a gift tax effect through the creation of a taxable transfer, or an estate tax effect through the creation of a taxable gift that becomes an adjusted taxable gift.

These rules apply only to loans of money. They specifically apply to gift loans, compensation-related loans, corporation-shareholder loans, tax avoidance loans, certain loans to continuing care facilities, and other below-market loans if the interest arrangement has a significant effect on the federal tax liability of the borrower or the lender. The IRS has authority to exempt any class of transactions from these rules if there is no significant effect on any federal tax liability of the borrower or the lender as a result of the interest arrangements.

For below-market loans other than demand or gift loans, the lender is treated as transferring and the borrower is treated as receiving, on the date of the loan, an amount equal to the excess of the loan amount over the present value of all principal and interest payments under the loan. All amounts are included by the lender and deducted by the borrower under original issue discount (OID) principles.

De minimis rules create exceptions for gift loans, compensation-related loans, and corporation-shareholder loans, if the aggregate amount of loans between the borrower and the lender does not exceed $10,000. In addition, in the case of a gift loan between individuals, the amount of the deemed transfers is limited to the net investment income of the borrower, if the aggregate amount of loans between the individuals does not exceed $100,000.

If a loan is subject to the rules discussed above, special reporting requirements apply to both the borrower and the lender.

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