Imputed Interest

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DEFINITION of 'Imputed Interest'

A term that describes interest that is considered to be paid for tax purposes even though no interest payment has been made. Imputed interest is used by the Internal Revenue Service (IRS) as a means of collecting tax revenues on loans or securities that do not pay interest, or where the stated interest is particularly low. Imputed interest is calculated based on the actual payments that will be - but have not yet been - paid. The interest is important for discount bonds, such as zero-coupon bonds, and other securities that are sold below face value and mature at par.

BREAKING DOWN 'Imputed Interest'

The IRS uses an accretive method to calculate the imputed interest on Treasury bonds, which are taxed yearly even though no interest is paid prior to maturity. To generate taxes on interest income that may or may not have been paid (such as with no-interest loans between family members), the IRS established Applicable Federal Rates (AFR) with the Tax Act of 1984, which sets a minimum interest rate for any loan that is made below a specified interest rate level. Each month, the IRS publishes base interest rates known as the Applicable Federal Rates, which are used for imputed interest and original issue discount rules.

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