What is an unspecified interest payment?
Unstated interest paid is the amount the IRS assumes has been paid to sellers who sell items in installments. In some cases, when you sell an item in installments but charge the customer little or no interest, undeclared interest must be calculated. Because interest income must sometimes be treated differently from other types of income, it may be necessary to estimate which part of the installment is actually interest income.
Understanding Unspecified Interest Paid
Unstated interest paid applies only to contracts that do not include interest payments, or when the interest charged is lower than the test rate. If the contract or invoice describes both the payment of interest and the payment of principal, the payment of interest is referred to as stated interest. The interest stated in the installment contract must be higher than the test rate, which in most cases is based on the applicable federal rate (AFR).
The applicable federal tax rate is calculated by the IRS and published monthly online and in various financial news sources. The IRS publishes three different applicable tax rates: short-term, medium-term and long-term. Short-term interest rates are calculated by averaging the rates the government pays for bond issues with maturities of three years or less. Medium-term rates are derived by averaging the rates paid on Treasury bonds with maturities of 3 to 9 years, while long-term rates are based on bonds with maturities of 10 years or more.In order to calculate unstated interest paid, sellers of installment merchandise shall select the applicable federal rate based on the term of the installment contract.
Example of Unstated Interest Paid
Suppose Ernie’s Tractor Supply Company sells a tractor to a customer for $10,000 and allows the customer to pay for the tractor in installments: $5,000 six months from now and $5,000 from now. The amount of interest to be paid is not specified in the customer contract for this installment plan. For tax purposes, you may need to recognize that this arrangement involves two implicit loans of $5,000 to the customer: one for six months and the other for one year.
If the applicable federal interest rate on this loan is 2% per year, the interest you pay on two $5,000 loans will end up being about $150. The IRS assumes you sold your tractor for $9,850 and made two loans paying $150 in interest income.