The price that a purchaser is willing to pay for property
will increase if the purchaser can obtain financing on favorable terms, whether
the financing is provided directly by the seller, from a third party, or in the
assumption of a mortgage. The latter category includes: the buyer acquires the
property “subject to the debt” without taking on personal liability; the buyer
and seller are jointly or severally liable for the debt; or, the buyer becomes
liable for the debt and the seller is released from liability.
Under the Deficit Reduction Act of 1984 (DEFRA), Congress
added Section 7872 to the Internal Revenue Code in 1984 so that interest free
loans and below market loans would be taxed in accordance with their economic substance.
Section 7872 operates by imputing interest on loans that do not charge a market
rate of interest.
A loan is any extension of credit including purchase money
mortgage, in which the owner of money permits another person to use the money
for a period of time after which the money is to be transferred to the owner or
applied accordingly to an express or implied agreement with the owner. Treas.
Reg. {1.7872-2(a)}.
A taxpayer’s characterization of a transaction as a
prepayment or loan is not conclusive. Transactions will be characterized for
tax purposes according to their economic substance rather than the terms used
to decide them. Id.
A below market loan is a loan that does not require payment
of interest at a rate at least equal to the Applicable Federal Rate (AFR).
Treas. Reg. {1.7872-3(a)}.
The AFR is divided into three categories: (1) A short-term
rate that applies to loans having a maturity of three years or less; (2) A
mid-term rate that applies to loans having maturity of more than three years or
less than nine years; and (3) A long-term rate that applies to loans having a maturity
of nine years or more from the date of issue. Sec. 1274(d).
The rates are determined by the Treasury Department within
15 days after the close of six month periods ending on September 30 and March
31. The rates determined to reflect the average yield for a six month period
ending on September 30 are applicable during the six month period
beginning on January 1 of the succeeding calendar year. The rates determined to
reflect the average yield for the period beginning on the following July 1.
Treas. Reg. {1.7872-3(b)(1)}
Sec. 7872 does not apply to any loan which has sufficient
states interest. A loan has sufficient interest if it provides for interest on
outstanding loan balance as a rate no lower than the applicable Federal rate
based on compound period appropriate for the loan. Treas. Reg. {1.7872-3(3)(c)}.
The term demand loan means any loan which is payable in full
at any time on demand of the lender. It includes any loan with an indefinite
maturity and any loan if the benefits of the interest arrangements of such
loans are not transferable and are conditioned on the future performance of
substantial service by an individual. Sec. {(7872(e)}.
The AFR for demand loans is the short term AFR. The demand
loan becomes a below market loan if the interest payable on the loan is at a
rate less than the applicable AFR. Sec. {7872(e)}.
The amounts of the loan are treated as transferred and
re-transferred on a daily basis and the applicable Federal rate for any day is
the relevant rate for the six month period in which such day falls. Tax
Management Sec. 535 p. B-409.
A term loan is any loan that is not a demand loan. The
applicable Federal rate is the rate for the day the loan is made and the
relevant rate is determined by the reference to the term of the loan short-term,
mid-term or long-term rate. Sec. {7872(e)}. A term loan becomes a below market
loan if the amount loaned exceeds the present value of all payments under the
loan, determined as of the day the loan is made, using a discount rate equal to
the applicable Federal rate in effect on the day of the loan is made. Treas.
Reg. {1.7872-3(a)(2)}.
Finally, the amount of loaned means the amount received by
the borrower.
For any questions or concerns, please feel free to contact
the law office of Arlington Heights attorney Robert S. Thomas.
1655 N Arlington Heights Rd, Suite 300West
Arlington Heights
IL 60004
847-392-5893 phone
info@attorneyrobertthomas.com
Se Habla Español
info@attorneyrobertthomas.com
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