Imputed Interest

In a mortgage that names an insufficient interest rate, The law will require that the rate be seen higher and the principal be seen less. Example: Abel sells property to Baker. Baker gives Abel a portion of the price in cash and Abel takes a note for the remainder. Since the gain on the sale is taxable at capital gains rates and the interest paid on the note is taxed as ordinary income, it is in Abel’s favor to set a higher price in exchange for charging a low rate of interest on the note. If this is done, the Internal Revenue Service will consider a portion of the principal paid on the note as imputed interest and tax that portion as ordinary income.