Applicable Federal Rate (AFR)

What Is the Applicable Federal Rate (AFR)?

The applicable federal rate (AFR) is the base interest rate that the Internal Revenue Service (IRS) considers private loans. Every month the IRS distributes a set of interest rates that the agency considers the base market rate for loans. Any interest rate that is not exactly the AFR would have tax implications. The IRS distributes these rates as per Section 1274(d) of the Internal Revenue Code.

Understanding the Applicable Federal Rate (AFR)

The AFR is involved by the IRS as a point of comparison versus the interest on loans between related parties, like family members. Assuming that you were giving a loan to a family member, you would should be certain that the interest rate charged is equivalent to or higher than the base applicable federal rate.

The IRS distributes 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, like U.S. government T-bills with maturities of three years or less. Mid-term AFR rates are from obligations of maturities of more than three and as long as nine years. Long-term AFR rates are from bonds with maturities of over nine years.

In addition to the three fundamental rates, the decisions in which the AFRs are distributed contain several other rates that fluctuate as per compounding period (annually, semi-annually, quarterly, monthly) and different other criteria and situations.

Illustration of How to Use the AFR

As of Apr. 2022, the IRS stated that the annual short-term AFR was 1.26%, the mid-term AFR was 1.87%, and the long-term AFR was 2.25%. Kindly bear as a primary concern that these AFR rates are subject to change by the IRS.

Which AFR rate to use for a family loan would rely upon 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 have to charge the borrower a base interest rate of 1.26% for the loan. In other words, you ought to receive $126 in interest from the loan.

In our model over, any rate below 1.26% could trigger a taxable event. For instance, let's say you gave a similar loan, but you didn't charge any interest. By not charging any interest, you would have "foregone" $126 in interest income, and as per the IRS, it would be viewed as a taxable gift. Any interest rate charged below the stated AFR for the particular term of the loan would be viewed as foregone interest and, as a result, be taxable.

Special Considerations

While getting ready to make a loan between related parties, taxpayers ought to consider two factors to select the correct AFR. The length of the loan ought to relate to the AFRs: short-term (three years or less), mid-term (as long as nine years), and long-term (over nine years).

In the event that the lender charges interest at a lower rate than the legitimate AFR, the IRS might rethink the lender and add imputed interest to the income to reflect the AFR rather than the actual amount paid by the borrower. Likewise, on the off chance that the loan is more than the annual gift tax exclusion, it might trigger a taxable event, and income taxes might be owed. Contingent upon the circumstances, the IRS may likewise evaluate penalties.

Highlights

• On the off chance that the interest on a loan is lower than the applicable AFR, it might result in a taxable event for the parties in question.
• AFRs are utilized to determine the original issue discount, unstated interest, gift tax, and income tax results of below-market loans.
• Parties must utilize the AFR that is distributed by the IRS at the time when the lender initially makes the loan.