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.
FAQs
It is the minimum rate applicable to such loans under U.S. law. The AFR is implemented in the form of federal tax regulations that are enforced by the Internal Revenue Service (IRS). The applicable federal rate applies to loans where the interest rate is lower than the tax rate if the loan were to otherwise be income.
How do you use AFR rates? ›
How to Apply AFR in Personal Loans
- Determine the Loan Term: Assess whether the loan is short-term, mid-term, or long-term.
- Set the Interest Rate: Use the current AFR for the determined term as the minimum interest rate.
Key Takeaways
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.
What is the AFR 3 month rule? ›
1274(d)(2)(B)Lowest 3-MonthRate. For purposes of subparagraph (A), the term “lowest 3-month rate” means the lowest of the applicable Federal rates in effect for any month in the 3-calendar-month period ending with the 1st calendar month in which there is a binding contract in writing for such sale or exchange.
Which AFR rate to use for family loan? ›
A Lender should assess two main factors when selecting the appropriate IRS Applicable Federal Rate for a family loan: (1) The length of the agreed upon repayment term of the loan. (2) The IRS Applicable Federal Rate for that repayment term during the month in which the loan is made.
What is the $100,000 loophole for family loans? ›
The $100,000 Loophole.
To qualify for this loophole, all outstanding loans between you and the borrower must aggregate to $100,000 or less. Under this loophole, if the borrower's net investment income for the year is no more than $1,000, your taxable imputed interest income is zero.
How does AFR work in a loan? ›
The applicable federal rate (AFR) is the interest rate that applies to personal loans. It is the minimum rate applicable to such loans under U.S. law. The AFR is implemented in the form of federal tax regulations that are enforced by the Internal Revenue Service (IRS).
Do I have to charge interest on a family loan? ›
The IRS mandates that any loan between family members be made with a signed written agreement, a fixed repayment schedule, and a minimum interest rate. (The IRS publishes Applicable Federal Rates (AFRs) monthly.)
How does the federal funds rate work? ›
How Does the Federal Funds Rate Work? The Federal Open Markets Committee sets the federal funds rate—also known as the federal funds target rate or the fed funds rate—to guide overnight lending among U.S. banks. It's set as a range between an upper and lower limit. The federal funds rate is currently 5.25% to 5.50%.
Who uses the federal funds rate? ›
The federal funds rate is the major tool that the Fed uses to conduct monetary policy in the United States. By changing the federal funds rate, the Fed can alter the cost of borrowing in the economy, which in turn affects the demand for goods and services in general.
On the other side, the forgiveness or cancellation of an intra-family debt does not mean that the lender must recognize the unpaid interest. Be careful not to forgive accrued interest each year, or the IRS will look at the original loan as a gift versus a bona fide loan.
What are the current AFR rates? ›
June 2024
| The AFRs are as follows: | Annual | Semi- annual |
|---|
| Short-term (up to 3 years) | 5.12% | 5.06% |
| Mid-term (3 to 9 years) | 4.66% | 4.61% |
| Long-term (over 9 years) | 4.79% | 4.73% |
2254, which added section 382(f)(2) to the Code, indicates that the adjusted Federal long-term rate is to be computed as the yield on a diversified pool of prime, general obligation tax-exempt bonds with remaining periods to maturity of more than nine years.
Can I give my child an interest-free loan? ›
Interest-free loans
If you loan a significant amount of money to your kids — over $10,000 — you should consider charging interest. If you don't, the IRS can say the interest you should have charged was a gift.
Can AFR loans be refinanced? ›
Should AFR rates go down, a borrower can refinance the same as they would with a traditional commercial loan. There is the risk that the IRS may treat the interest savings as a taxable gift at the time of refinancing, at which time the lender may choose to apply the savings to their annual gift tax exclusion amount.
Do I have to pay taxes on a loan from a friend? ›
On the borrower's side, there are typically no tax implications. The borrower doesn't typically need to report the loan and won't pay any income tax on it. In some cases, the borrower may get a tax perk from borrowing money from family.
What is 110% AFR used for? ›
Taxpayers must test debt instruments in sale-leaseback transactions for adequate interest using a discount rate that is 110% of the applicable federal rate (AFR). For a discussion on determining the AFR, see How Is the Applicable Federal Rate (AFR) Determined for Discounting and Interest Purposes?.
How do you use high interest rates to your advantage? ›
You can capitalize on higher rates by purchasing real estate and selling off unneeded assets. Short-term and floating-rate bonds are also suitable investments during rising rates as they reduce portfolio volatility. Hedge your bets by investing in inflation-proof investments and instruments with credit-based yields.
When to use afr vs adjusted afr? ›
Long-term AFRs apply to loans of more than nine years. The Adjusted AFR is used to determine the compounding interest rate over a period of time. Short-term AFRs apply to loans with a maturity period of three years or less. Mid-term AFRs apply to loans of more than three years but not more than nine years.
