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J.K. Lasser's Your Income Tax 2013: For Preparing Your 2012 Tax Return by J.K. Lasser Institute

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4.31 Interest-Free or Below-Market-Interest Loans

For many years, the IRS tried to tax interest-free or below-market-interest loans. However, court decisions supported taxpayers who argued that such loans did not result in taxable income or gifts. To reverse these decisions, the IRS convinced Congress to pass a law imposing tax on interest-free or low-interest loans made by individuals and businesses. You may not make interest-free or low-interest loans to a relative who uses the loan for personal or investment purposes without adverse income tax consequences, unless the exception discussed in this section for $10,000 or $100,000 loans applies.

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Get Professional Advice To Draft Loan Agreement
Given the complexity of the imputed interest rules and exceptions, you and your tax advisor should carefully review regulations to the Internal Revenue Code Section 7872 when drafting a loan agreement.
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How the imputed interest rules work.

If interest at least equal to the applicable federal rate set by the IRS is not charged, the law generally treats a below-market-interest loan as two transactions:

1. The law assumes that the lender has transferred to the borrower an amount equal to the “foregone” interest element of the loan. In the case of a loan between individuals, such as a parent and child, the lender is subject to gift tax on this ...

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