CFP® Exam Prep: Below-Market Rate Loans and Imputed Interest Rules

Back to Blog
Below-Market Rate Loans and Imputed Interest Rules

Understanding income taxes is vitally important as part of your CFP® exam prep. Unfortunately, the majority of you sitting for the exam do not have a tax background, which can make the tax questions challenging. Two of the areas where you can ensure success, if a few rules are understood and retained, are below market loans and imputed interest.

The Big Picture

The IRS doesn’t like the idea of having someone lending another person money at an interest rate they deem “too low.” That’s because there are times where individuals and companies try to work around income taxes by disguising things such as compensation, dividends and other types of taxable income as loans; compensation is taxable but a loan is not since it has to be repaid (think of a loan from your 401k or from the cash value of a life insurance policy). Therefore, if you don’t charge a borrower the appropriate amount of interest on a loan, then the IRS might (and I stress might) include the amount of income you should have collected in your gross income. How very thoughtful of them.

So how do you know how much interest to charge a borrower and what are the tax consequences of a below market loan? The answer depends on two things:

  1. The amount of the loan and
  2. The amount of investment income that the borrower generates during the year in question

Please Forgive Me!

There are a few scenarios you’ll have to be aware of as it relates to imputed interest on below-market loans on the Certified Financial Planner™ exam. Take note that in the first and second scenarios below, there is no imputed income added to the taxpayer’s gross income:

  1. If you’re going to make a below-interest loan to somebody (e.g. to your child at no cost) and the amount of the loan is $10,000 or less, then the IRS won’t care; they will not have imputed interest added to your income.
  2. If you lend someone less than $100,000 AND the borrower’s net investment income on the year is less than $1,000, the IRS won’t care and they will not have imputed interest added to your gross income.
  3. If you lend someone more than $10,000, but less than $100,000 and the borrower NOT the lender – but the borrower has net investment income on the year, you’ll have to include in your income the lesser of the imputed interest amount (i.e. what the IRS say’s you should be charging the borrower) or the borrower’s net investment income. How much does the borrower know what to charge? It’s called the Applicable Federal Rate, or AFR, and it will be given to you on the CFP® exam. Here’s an example:

On January 1 of the current year, Dan loaned his son Sonny $80,000 and didn’t charge Sonny anything for the loan. The Applicable Federal Rate at the time was 5%. Sonny has been saving his money over the years and now has enough invested so that he generates $5,000 annually of investment income. When Dan does his taxes the following year, he’ll have to report imputed interest in the amount of $4,000. This is because he made a below-market loan of more than $10,000 but less than $100,000 and when determining how much income he needs to report, he’ll impute/add the lesser of what he should have charged (i.e. the AFR of 5% multiplied by the loan amount of $80,000 for a total of $4,000) or his son’s investment income of $5,000.

4. If you lend someone $100,000 or more, then there is no forgiveness and you’ll include in your income an amount equal to the AFR multiplied by the loan amount.

The concepts of below-market loans and imputed interest are sure to pop up on the Certified Financial Planner™ exam, but simply memorizing the rules above should score you some valuable points. Finally, be aware that the Board will probably include the lender’s investment income in the question, but it’s important that you only consider the borrower’s investment income. The lender’s investment income is simply there to confuse you, so don’t fall for their trap.

Share this post

Back to Blog

Tackle Your Toughest Exam Questions