Prepared by Worldwide ERC® Tax Counsel, Peter K. Scott
Peter Scott Associates
Current as of January, 2017
A. Types of relocation loans
- Mortgage loans
A mortgage loan is extended by the employer to the employee with the understanding that the employee will use the proceeds of the loan to purchase a new principal residence. Such loan may be a demand or term loan, and is conditioned on the future performance of substantial services for the employer. The loan may have a market interest rate, a below market interest rate, or no interest at all.
- Equity bridge loans
A loan may be offered to an employee in order to enable the employee to receive the equity out of an old unsold residence to make the down payment on a new residence. The terms of the loan may require that the proceeds be repaid within a short time after the sale of the former residence. The loan may have a market interest rate, or a below market interest rate, or no interest at all.
B. Imputation of interest on a loan transaction
- Explanation of imputed interest
When a loan is made at a below market interest rate, or with no interest at all, the Internal Revenue Code may impute interest to the loan even though the lender and borrower never did. If imputed interest rules apply to an employee relocation loan, the amount by which a market rate of interest exceeds the loan’s actual rate of interest is considered income to the employee borrower. (The market rate used is the "applicable federal rate," which is computed by the IRS under a formula in the Internal Revenue Code and periodically adjusted.) This income is considered to be derived from the employer-lender, because the employer-lender is considered to have paid interest on the loan to itself on behalf of the employee-borrower.
- An example of imputed interest
An example of imputed interest may be helpful in understanding this complex area. Assume that the employer has made an interest-free bridge loan to the employee. The market rate of interest on the loan would be $100 per month if interest were charged by the employer-lender. No interest is paid by the employee-borrower or received by the employer-lender. However, the tax law considers the employee-borrower to have owed $100 of interest, and since the employee’s obligation to pay this $100 was satisfied by the employer-lender, the transaction is treated as though the employer-lender paid $100 per month to the employee-borrower, who then repaid it to the employer-lender. This characterization of the transaction gives rise to $100 per month of compensation income to the employee-borrower.
- Reporting requirements for imputed interest
The employee-borrower must report imputed income on his/her tax return, even though the employee never received it, but then may be entitled to a corresponding deduction for the interest theoretically paid on the employee’s behalf by the employer-lender.
- Negative tax consequences of imputed interest
If interest is imputed to loans it has negative tax consequences for the employer-lender and may have for the employee-borrower. The employer-lender must pay payroll taxes (FICA, RRTA, and FUTA) on the amounts imputed as interest income to the employee-borrower. (The employer-lender, however, does not have to withhold federal income taxes on the imputed interest income.) The employee-borrower may or may not be eligible for a deduction of the imputed interest. The interest on a mortgage or bridge loan may be deductible as "qualified residence interest" under the general rules applicable to homeowners. However, there may be situations in which interest income is imputed to the employee, but the employee is unable to take a corresponding interest deduction. For example, there is a $100,000 limit on the amount of home equity debt upon which interest is deductible.
C. Avoidance of imputed interest
- De minimis exception
If the total principal amount of the employer’s mortgage loan, bridge loan, or both outstanding to the employee does not exceed $10,000 during the year, the loans are ex-empted from the imputed interest rules due to their small size. No interest will be imputed in this situation.
- Exemption for employee relocation loans under regulation 1.7872-5T
Under a temporary regulation, imputed interest will not apply to compensation-related mortgage or bridge loans if the following requirements are met:
- Exemption for mortgage loans
The loan agreement must require that the proceeds of the loan be used only to purchase the new residence. Such loans must be secured by a mortgage on the new principal residence acquired in connection with the relocation of the employee to a new principal place of work. The loan must be a demand or term loan. The benefits of the interest arrangements must not be transferable, and the below market interest rate (or the lack of interest) must be conditioned on the future performance of substantial services by the employee. The employee must certify to the employer that the employee reasonably expects to itemize deductions for each year the loan is outstanding.
- Exemption for bridge loans
The terms of the bridge loan must meet all the requirements for the mortgage loan, except for the security requirement. Note, however, that any interest actually charged on a bridge loan will not be deductible by the transferee unless the loan is secured by either the old or new residence. In addition, the bridge loan agreement must provide that the loan is payable in full within 15 days after the sale of the employee’s immediately former principal residence. The aggregate of the principal amount of all outstanding bridge loans must not be greater than the employer’s reasonable estimate of the equity in the former residence. The former residence must not be converted to business or investment use.
- An unresolved issue
One issue that remains unresolved under the temporary regulation is whether the exemption applies in situations where imputed interest would not be deductible under the general rules applicable to home mortgage loan interest deductions. This problem is particularly acute for bridge loans, which are often unsecured by either the old or new residence, and, even if secured by the old residence may be considered home equity loans, and therefore limited to $100,000 of principal on which interest would be deductible. Although the IRS has not spoken to this issue, it is arguable that the 1986 Tax Reform Act, which imposed the current limitations on deductibility of interest, would be held to modify the exemption contained in the temporary regulation. However, in the absence of any IRS statement of position, it should be assumed that the regulation may still be relied upon. The IRS continues to follow the regulation, and has shown no interest in revisiting it.
The foregoing is intended as general information only. Regarding your specific situation, Worldwide ERC® suggests that you consult with your own tax or legal advisor as appropriate.
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