Jonathan has bought a new house and has been having trouble selling the old one. He has just reduced the asking price for the second time and his problem is about to get worse. The escrow on his new house is due to close next week, and he cannot afford to make the payments on both houses.
However, he has one interesting offer. Someone has agreed to pay his latest asking price if he will carry back a substantial second trust deed at 6% interest. Monthly, interest-only payments would be made on the note for 10 years, at which time the principal would be due and payable. Since this is the only offer in sight, Jonathan reluctantly accepts.
The bad news comes when Jonathan realizes that, for tax purposes, this "bargain rate" loan is not reportable at face value. In fact, a rather complex set of rules must be applied to determine its proper tax treatment. Under changes to the tax law enacted over the past two years, most loans that provide for interest rates lower than the minimum rate provided in the tax law must be analyzed and recharacterized to reflect their economic substance.
The minimum interest rate that Jonathan would have to charge to avoid adjustment is the lesser of 9% compounded semiannually or the "applicable federal rate" (AFR). The 9% ceiling applies only to seller financing on sales of property, such as Jonathan's residence, where the face amount of the seller financing does not exceed $2.8 million.
The AFR is actually a series of rates covering loans of various terms and compounding periods that change each month. These rates are based on the weighted average of yields of publicly traded U.S. obligations with comparable maturities.
For example, the January, 1986, AFR for loans like Jonathan's second trust deed note was 9.69%. Thus, 9% compounded semiannually, the lower rate, will be used to discount Jonathan's 6% note and arrive at the necessary adjustment to the terms of the note.
The required adjustment will take the form of recharacterizing the principal payment at the end of the 10th year. In fact, a substantial portion of that payment will be treated as interest income, with a corresponding decrease in the principal amount.
Aside from increasing Jonathan's tax liability in the year that he receives the payoff, this adjustment will also reduce the selling price (for tax purposes only) of the old house and increase the accounting value of Jonathan's new house. If the note had called for other principal payments during the 10 years, each such payment would have had to be similarly adjusted.
Carrying out this example one step further, in order for Jonathan to afford the new house, he persuades his employers to lend him, payable on demand, an amount equal to the second trust deed note. In lieu of a raise, Jonathan's employer agrees to make the loan interest-free.
This type of loan requires a different set of adjustments. For loans not associated with sales of property that call for interest rates below the AFR (the 9% ceiling rate does not apply here), the nature of the adjustment depends on the relationship between the parties to the loan. The three main types of such loans are gift loans, compensation loans and corporation-shareholder loans. The interest foregone by the lender is treated in a manner that depends on the type of loan.
In Jonathan's case, the news is not so bad, though complicated. Since the loan is payable on demand, Jonathan and his employer are deemed to make reciprocal transfers once a year. (If the loan had a specified term, the tax consequences would be different.)
In Jonathan's transfer, he is deemed to have paid his employer interest on the loan at the AFR. (The January, 1986, AFR for demand loans with annual compounding was 8.32%.) In the employer's transfer, since this is a compensation loan, his employer is deemed to have paid Jonathan additional compensation in a like amount.
At first glance, Jonathan seems to break even: He has additional compensation income offset by equal an amount of interest expense. However, his adjusted gross income (AGI) is raised by the compensation, which may affect deductions based on a percentage of AGI (medical expenses, casualty losses, etc.).
Also, if his normal salary is below the Social Security wage base--$42,000 for 1986--both he and his employer will have to pay additional Society Security tax on the deemed compensation income.
The news is much worse for gift loans or corporation-shareholder loans. While the deemed transfer of interest will still result in a deduction to the borrower and income to the lender, the reciprocal transfer can have much different tax consequences. In the case of a gift loan, not only does the deemed payment of a gift not give rise to an offsetting deduction for the lender, it may give rise to a gift tax. Happily for the borrower, receipt of a gift is not taxable.
The worst scenario occurs with corporation-shareholder loans. There, the reciprocal transfer will usually be a dividend, non-deductible by the corporation/lender but fully taxable to the shareholder/borrower.
It is particularly important to note that these tax consequences result even though no cash changes hands.
This brief discussion only scratches the surface of these complicated rules. Filling in the landscape is a tight web of exceptions, exemptions, limitations and cross-references. The important message is that failure to provide a proper interest rate can produce unexpected tax consequences.