What Is the Applicable Federal Rate (AFR)?
The applicable federal rate (AFR) is the lowest interest rate allowed by the Internal Revenue Service (IRS) on private loans. The IRS publishes a set of interest rates each month that it considers to be the minimum market rate for loans. 1 Any interest rate lower than the AFR would be subject to taxation. The IRS publishes these rates in accordance with Internal Revenue Code Section 1274(d). Learn more on how to earn money on youtube.
- If the interest rate on a loan is less than the applicable AFR, the parties involved may face a taxable event
- AFRs are used to calculate the original issue discount, unstated interest, gift tax, and income tax implications of subprime loans
- Parties must use the AFR published by the IRS at the time the lender makes the initial loan.
Understanding the Applicable Federal Rate (AFR)
The AFR is used by the IRS to compare interest rates on loans between related parties, such as family members. If you were to make a loan to a family member, you must ensure that the interest rate charged is equal to or greater than the minimum applicable federal rate.
The IRS issues three types of AFRs: short-term, mid-term, and long-term. Short-term AFR rates are calculated by taking a one-month average of market yields on marketable obligations. Such as US government T-bills with maturities of three years or less. Mid-term AFR rates are derived from obligations with maturities ranging from three to nine years. Long-term AFR rates are derived from bonds with maturities greater than nine years.
Example of How to Use the AFR
According to the IRS, the annual short-term AFR was 1.26 percent in April 2022, the mid-term AFR was 1.87 percent, and the long-term AFR was 2.25 percent. Please keep in mind that the IRS may change these AFR rates at any time.
The AFR rate to use for a family loan would be determined by the length of time allotted for repayment.
Assume you were to make a $10,000 loan to a family member that was to be repaid in one year. For the loan, you must charge the borrower a minimum interest rate of 1.26 percent. In other words, the loan should pay you $126 in interest.
You would have “foregone” $126 in interest income if you did not charge interest, and the IRS would consider it a taxable gift.
Any interest rate charged that is less than the stated AFR for the term of the loan would be considered foregone interest and thus taxable.
Taxpayers should consider two factors when deciding on the appropriate AFR for a loan between related parties. The loan term should correspond to the AFRs: short-term (three years or less), mid-term (up to nine years), and long-term (up to ten years) (more than nine years).
If the lender charges interest at a rate lower than the proper AFR, the IRS may reassess the lender. And add imputed interest to the borrower’s income to reflect the AFR rather than the actual amount paid. Furthermore, if the loan exceeds tax exclusion,The IRS may levy penalties. To know more about giffen goods, click here.