IRS Publication 550 — Investment Income and Expenses
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“• Qualified 501(c)(3) bonds. • New Y ork Liberty bonds. • Gulf Opportunity Zone bonds. • Midwestern disaster area bonds. • Hurricane Ike disaster area bonds.”
Generally, a “below-market loan” means any loan if (a) in the case of a demand loan, interest is payable on the loan at a rate less than the applicable federal rate, or (b) in the case of a term loan, the amount loaned exceeds the present value (using a discount rate equal to the applicable federal rate) of all payments due under the loan. (See Code section 7872 for details.) Section 7872 may consider the borrower to pay the lender any forgone interest and the lender to pay that foregone interest to the borrower. Thus, the lender may be compelled to recognize that foregone interest as income and the borrower may be able to deduct that foregone interest as an expense if the loan proceeds are used for business or investment. The nature of the forgone interest that section 7872 considers the lender to return to the borrower depends on the relationship between lender and borrower. It may be considered a gift, an investment, compensation, etc. Loans subject to the rules. The rules for below -market loans apply to:
• Gift loans,
• Compensation-related loans,
• Corporation-shareholder loans,
• Tax avoidance loans, and
• Certain loans made to qualified continuing care facilities under a continuing care contract. A compensation-related loan is any below -market loan between an employer and an employee or between an independent contractor and a person for whom the contractor provides services. A tax avoidance loan is any below -market loan where the avoidance of federal tax is one of the main purposes of the interest arrangement.
Forgone interest. For any period, forgone interest is:
• The amount of interest that would be payable for that period if interest accrued on the loan at the applicable federal rate and was payable annually on December 31, minus
• Any interest actually payable on the loan for the period. Applicable federal rate. Applicable federal rates are published by the IRS each month in the Internal Revenue Bulletin. The Internal Revenue Bulletin is available through IRS.gov/IRB. You also can find applicable federal rates in the Index of Applicable Federal Rates (AFR) Rulings at IRS.gov/applicable-federal-rates.
See chapter 5, How To Get Tax Help, for other ways to get this information.
Rules for below-market loans. The rules that apply to a below-market loan depend on whether the loan is a gift loan, demand loan, or term loan.
Gift and demand loans. A gift loan is any below -market loan where the forgone interest is in the nature of a gift. A demand loan is a loan payable in full at any time upon demand by the lender. A demand loan is a below -market loan if no interest is charged or if interest is charged at a rate below the applicable federal rate.
A demand loan or gift loan that is a below -market loan generally is treated as an arm's -length transaction in which the lender is treated as having made:
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