What Is Unstated Interest Paid?
Let me tell you directly: unstated interest paid is the amount of money the Internal Revenue Service (IRS) assumes is being paid for a sale that takes more than one year to pay in full. If your contract for installment payments doesn't state an interest rate, or if the stated rate is lower than the applicable federal rate, the remainder is considered unstated interest.
Key Takeaways
Unstated interest paid is the percentage of interest the IRS assumes has been charged for a payment plan longer than one year. The IRS assumes this even if no interest is listed on the installment plan contract. For tax purposes, you may need to recognize that the installment plan means the customer is receiving a loan for each segment—and that loan comes with interest, depending on the length of each installment.
Understanding Unstated Interest Paid
Unstated interest paid is only calculated for contracts where interest payments are not included, or when the interest charged falls below the test rate of interest. If a contract or invoice describes both an interest payment and a principal payment, that's stated interest. Stated interest in an installment contract must be greater than the test rate, which in most cases is based on the applicable federal rates (AFRs).
The applicable federal rate is calculated by the IRS and published monthly online and by various financial news sources. The IRS publishes three different rates: short-term, mid-term, and long-term. The short-term rate comes from averaging rates on government bond issues with maturities of three years or less. The mid-term rate is from averaging rates on Treasury securities between three and nine years, while the long-term rate is based on issues of ten years or longer.
Important Note on Calculation
To calculate unstated interest paid, if you're a seller of goods paid for on installment, you should choose the applicable federal rate based on the length of the installment contract.
Example
Let's say Preeti’s craftsman furniture company sells a dining room table to a customer for $10,000, allowing payment in installments: $5,000 six months from now, and another $5,000 one year from now. On the contract, there's no stipulated interest. For tax purposes, Preeti may need to recognize this as implicitly lending the customer two $5,000 loans: one maturing in six months, the other in one year.
If the applicable federal rate for this is 2% per year, the interest on the two $5,000 loans would be roughly $150. The IRS would assume Preeti sold the table for $9,850 and issued two loans paying interest income of $150.
What Does Interest Mean?
Interest is what's accumulating on the initial balance of the loan at a given rate. It may be calculated as a percentage of the principal borrowed. Interest can be simple, on principal only, or compounding, on interest as well. Compounding interest can generate wealth in retirement savings like a 401(k) or IRA, or drive you deeper into debt with credit cards.
What Does Principal Mean?
The principal is the initial sum of money deposited into an account or used as a loan. It's what interest accrues on. Returns from investments are calculated based on the principal balance. With a loan like a mortgage, the principal is what's borrowed to purchase the home or land, and interest is additional.
What Are the Advantages of Compound Interest?
Compound interest can seem almost magical for generating wealth, such as for retirement. In a high-yield savings account or investment account, it grows on itself quickly. The U.S. Securities and Exchange Commission has a compound interest calculator on its website.
For example, if you're saving for retirement and make $104,000 a year, one rule is to invest enough to get your employer match, say 4%. That's $4,160 a year, or about $346.66 per month, with your employer matching. Using the SEC calculator at 7% interest, in a decade you'll have about $115,000; in two decades, $341,000; in three, $786,000. You can see how it compounds: the two-decade figure is more than twice the one-decade, and three decades far more than three times.
What Are the Disadvantages of Compound Interest?
With a credit card, any balance carried month to month incurs interest that compounds, calculated on both principal and accumulated interest. This makes it harder to pay off the balance. Another disadvantage is that compound interest is a bit difficult to understand and calculate.
The Bottom Line
Unstated interest paid is an amount the IRS assumes has been paid to the seller in an installment sale. You must calculate it in some cases when selling on installment with little or no interest charged. Because interest income may be treated differently than other income for taxes, estimate which portion of the payment is actually interest.
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