Imputed interest is a term used to describe interest that is considered to be paid, even though no interest payment has been made as defined by Investopedia. Imputed interest is mainly used by the IRS for taxes. It is a tool to collect tax revenues on loans that don't pay interest. Imputed interest is also required to be paid on certain bonds that don't pay interest. One example of this is a
. Zero-coupon bond. These bonds are usually sold at a discount and without interest. Bond holders of zero-coupon bonds have to report annual interest to the IRS.Imputed interest was established after the IRS realized there were many low or no interest loans being made to close parties that were not being taxed. It was also created to prevent wealthy people from being able to lend money to their children in lower tax brackets so their child could invest and pay less taxes on the return. The IRS instituted Applicable Federal Rates in 1984 in order to collect taxes on the no or very low interest loans. Simply speaking, imputed interest was created to prevent the transfer of wealth in hopes of avoiding higher tax rates.One example where imputed interest would be applied is if a friend of the family loaned the family $50,000 for a business start up fund. At this time, the federal interest rate is 5%. The government would then calculate the interest on the $50,000 by this equation: $50,000 x .05 = $2500. The friend of the family would then be required to list the $2500 on their federal tax return as interest income although they never actually earned the interest from the loan. In turn, the family friend would be required to pay taxes on the $2500. This is how imputed interest is calculated. More reference links: http://www.investopedia.com/terms/i/imputedinterest.asp#axzz1hC59erf6 http://www.irs.gov/app/picklist/list/federalRates.html
