Page 18

deduction by the refund. If you receive the re- fund in a later tax year, include the refund in your income to the extent the deduction for the interest reduced your tax. Accrual method. Under an accrual method, you can deduct only interest that has accrued during the tax year. Prepaid interest. You generally cannot de- duct any interest paid before the year it is due. Interest paid in advance can be deducted only in the tax year in which it is due. Discounted loan. If interest or a discount is subtracted from your loan proceeds, it is not a payment of interest and you cannot deduct it when you get the loan. For more information, see Original issue discount (OID) under Interest You Can Deduct, earlier. Tax deficiency. If you contest a federal in- come tax deficiency, interest does not accrue until the tax year the final determination of liabil- ity is made. If you do not contest the deficiency, then the interest accrues in the year the tax was asserted and agreed to by you. However, if you contest but pay the pro- posed tax deficiency and interest, and you do not designate the payment as a cash bond, then the interest is deductible in the year paid. Related person. If you use an accrual method, you cannot deduct interest owed to a related person who uses the cash method until payment is made and the interest is includible in the gross income of that person. The relation- ship is determined as of the end of the tax year for which the interest would otherwise be de- ductible. See section 267 for more information. Below-Market Loans If you receive a below-market gift or demand loan and use the proceeds in your trade or busi- ness, you may be able to deduct the forgone in- terest. See Treatment of gift and demand loans, later, in this discussion. A below-market loan is a loan on which no interest is charged or on which interest is charged at a rate below the applicable federal rate (AFR). A gift or demand loan that is a be- low-market loan generally is considered an arm's-length transaction in which you, the bor- rower, are considered as having received both the following. • A loan in exchange for a note that requires the payment of interest at the AFR. • An additional payment in an amount equal to the forgone interest. The additional payment is treated as a gift, divi- dend, contribution to capital, payment of com- pensation, or other payment, depending on the substance of the transaction. Forgone interest. For any period, forgone in- terest is: 1. The interest that would be payable for that period if interest accrued on the loan at the AFR and was payable annually on De- cember 31, minus 2. Any interest actually payable on the loan for the period. AFRs are published by the IRS each month in the I.R.B. I.R.B.s are available on the IRS web site at IRS.gov/irb. You can also contact an IRS office to get these rates. Loans subject to the rules. The rules for be- low-market loans apply to the following. 1. Gift loans (below-market loans where the forgone interest is in the nature of a gift). 2. Compensation-related loans (below-mar- ket loans between an employer and an employee or between an independent contractor and a person for whom the con- tractor provides services). 3. Corporation-shareholder loans. 4. Tax avoidance loans (below-market loans where the avoidance of federal tax is one of the main purposes of the interest ar- rangement). 5. Loans to qualified continuing care facilities under a continuing care contract (made af- ter October 11, 1985). Except as noted in (5) above, these rules apply to demand loans (loans payable in full at any time upon the lender's demand) outstand- ing after June 6, 1984, and to term loans (loans that are not demand loans) made after that date. Treatment of gift and demand loans. If you receive a below-market gift loan or demand loan, you are treated as receiving an additional payment (as a gift, dividend, etc.) equal to the forgone interest on the loan. You are then trea- ted as transferring this amount back to the lender as interest. These transfers are consid- ered to occur annually, generally on December 31. If you use the loan proceeds in your trade or business, you can deduct the forgone interest each year as a business interest expense. The lender must report it as interest income. Limit on forgone interest for gift loans of $100,000 or less. For gift loans between indi- viduals, forgone interest treated as transferred back to the lender is limited to the borrower's net investment income for the year. This limit applies if the outstanding loans between the lender and borrower total $100,000 or less. If the borrower's net investment income is $1,000 or less, it is treated as zero. This limit does not apply to a loan if the avoidance of any federal tax is one of the main purposes of the interest arrangement. Treatment of term loans. If you receive a be- low-market term loan other than a gift or de- mand loan, you are treated as receiving an ad- ditional cash payment (as a dividend, etc.) on the date the loan is made. This payment is equal to the loan amount minus the present value, at the AFR, of all payments due under the loan. The same amount is treated as OID on the loan. See Original issue discount (OID) un- der Interest You Can Deduct, earlier. Exceptions for loans of $10,000 or less. The rules for below-market loans do not apply to any day on which the total outstanding loans between the borrower and lender is $10,000 or TIP less. This exception applies only to the follow- ing. 1. Gift loans between individuals if the loan is not directly used to buy or carry in- come-producing assets. 2. Compensation-related loans or corpora- tion-shareholder loans if the avoidance of any federal tax is not a principal purpose of the interest arrangement. This exception does not apply to a term loan described in (2) above that was previously sub- ject to the below-market loan rules. Those rules will continue to apply even if the outstanding balance is reduced to $10,000 or less. Exceptions for loans without significant tax effect. The following loans are specifically ex- empted from the rules for below-market loans because their interest arrangements do not have a significant effect on the federal tax liabil- ity of the borrower or the lender. 1. Loans made available by lenders to the general public on the same terms and conditions that are consistent with the lender's customary business practices. 2. Loans subsidized by a federal, state, or municipal government that are made avail- able under a program of general applica- tion to the public. 3. Certain employee-relocation loans. 4. Certain loans to or from a foreign person, unless the interest income would be effec- tively connected with the conduct of a U.S. trade or business and not exempt from U.S. tax under an income tax treaty. 5. Any other loan if the taxpayer can show that the interest arrangement has no sig- nificant effect on the federal tax liability of the lender or the borrower. Whether an in- terest arrangement has a significant effect on the federal tax liability of the lender or the borrower will be determined by all the facts and circumstances. Consider all the following factors. a. Whether items of income and deduc- tion generated by the loan offset each other. b. The amount of the items. c. The cost of complying with the be- low-market loan provisions if they were to apply. d. Any reasons, other than taxes, for structuring the transaction as a be- low-market loan. Exception for loans to qualified continuing care facilities. The below-market interest rules do not apply to a loan owed by a qualified continuing care facility under a continuing care contract if the lender or lender's spouse is age 62 or older by the end of the calendar year. A qualified continuing care facility is one or more facilities (excluding nursing homes) meet- ing the requirements listed below. 1. Designed to provide services under con- tinuing care contracts (defined below). Chapter 4 Interest Page 17