What Is the Applicable Federal Rate (AFR)?
The applicable federal rate (AFR) is the minimum interest rate that the Internal Revenue Service (IRS) allows for private loans. Each month the IRS publishes a set of interest rates that the agency considers the minimum market rate for loans. Any interest rate that is less than the AFR would have tax implications. The IRS publishes these rates in accordance with Section 1274(d) of the Internal Revenue Code.
Key Takeaways
- If the interest on a loan is lower than the applicable AFR, it may result in a taxable event for the parties involved.
- AFRs are used to determine the original issue discount, unstated interest, gift tax, and income tax consequences of below-market loans.
- Parties must use the AFR that is published by the IRS at the time when the lender initially makes the loan.
Understanding the Applicable Federal Rate (AFR)
The AFR is used bythe IRS as a point of comparison versusthe interest on loans between related parties, such as family members. If you were giving a loan to a family member, you would need to be sure that the interest rate charged is equal to or higher than the minimum applicable federal rate.
The IRS publishes three AFRs: short-term, mid-term, and long-term. Short-term AFR rates are determined from the one-month average of the market yields from marketable obligations, such as U.S. government Treasury securities with maturities of three years or less. Mid-term AFR rates are from obligations of maturities of more than three and up to nine years. Long-term AFR rates are from bonds with maturities of more than nine years.
In addition to the three basic rates, the rulings in which the AFRs are published contain several other rates that vary according to compounding period (annually, semi-annually, quarterly, monthly) and various other criteria and situations.
Example of How to Use the AFR
As of May 2023, the IRS stated that the annual short-term AFR was 4.30%, the mid-term AFR was 3.57%, and the long-term AFR was 3.72%. Please bear in mind that these AFR rates are subject to change by the IRS.
Which AFR rate to use for a family loan would depend on the length of time designated for payback. Let's say you were giving a loan to a family member for $10,000 to be paid back in one year. You would need to charge the borrower a minimum interest rate of 4.30% for the loan. In other words, you should receive $430 in interest from the loan.
In our example above, any rate below 4.30% could trigger a taxable event. For example, let's say you gave the same loan, but you didn't charge any interest. By not charging any interest, you would have "foregone" $430 in interest income, and according to the IRS, it would be considered a taxable gift. Any interest rate charged below the stated AFR for the particular term of the loan would be considered foregone interest and, as a result, be taxable.
Special Considerations
When preparing to make a loan between related parties, taxpayers should consider two factors to select the correct AFR. The length of the loan should correspond to the AFRs: short-term (three years or less), mid-term (up to nine years), and long-term (more than nine years).
If the lender charges interest at a lower rate than the proper AFR, the IRS may reassess the lender and add imputed interest to the income to reflect the AFR rather than the actual amount paid by the borrower. Also, if the loan is more than the annual gift tax exclusion, it may trigger a taxable event, and income taxes may be owed. Depending on the circ*mstances, the IRS may also assess penalties.
Am I Required to Charge Interest When Loaning Money to Family?
No, you're not required to charge interest. However, by not doing so, the IRS may consider your loan a gift and levy taxes accordingly.
How Often Is the AFR Determined?
The AFR is released monthly with updated interest rates based on the market interest rates.
Does My Loan Agreement With a Family Member Have to Be Notarized?
No. While notarization may take it the next step, your written and signed agreement is legally binding on its own.
The Bottom Line
The applicable federal rate exists to set a standard for what differentiates a gift from a loan. Check this rate before loaning money to anyone—if you charge an interest rate less than this benchmark, you may be subject to gift taxes.
Correction—April 9, 2024: This article has been edited from a previous version that incorrectly referenced T-bills with maturity terms of up to three years. T-bills have maturities of one year or less.
