Tax considerations on 0% loans

Aug 12, 2020

In the US the government collects taxes on interest income from all loans an individual makes. Unfortunately, they also have opinions about what minimum rates borrowers should be charged as well. If a lender decides to make a loan at a rate less than the legislated minimum, they will still owe interest income taxes as if they charged the minimum rate.

Check the current minimum rates here.

This minimum rate is called the Applicable Federal Rate (AFR). It is, in our opinion, an unconscionable tax on income you didn't actually earn. The rational is that gift taxes can be evaded by calling gifted money a "loan" that the borrower simply never pays back. That said, the AFR rates are currently very low, so you're not actually going to be paying very much in taxes (if you pay anything at all). AFRs currently range from 0.17% to 1.47%. There are a fair number of exceptions and qualifications to this rule, so we encourage you to read 26 U.S. Code § 1274 if you are considering making an loan at less than the mandated AFR.

Some notable exceptions, as we currently understand them.

  • This only applies if you earn more than $600 in interest on loans to other individuals in the year.
  • This only applies if you lend more than $10,000 to any one individual
  • The AFR is locked in at the start of the loan. You won't need to recalculate with floating minimums.

Should you decide to pay taxes on a 0% loan, all you need to do is include the interest income you earned on your Form 1040.