Applicable Federal Rate (AFR)

Applicable Federal Rate (AFR): What it is and how to use it

The Applicable Federal Rate (AFR) is a set of minimum interest rates published monthly by the IRS that apply to private loans. AFRs prevent below-market family or related‑party loans from being treated as gifts for tax purposes and determine the minimum imputed interest the IRS will recognize for such loans.

Why AFRs matter

• If you lend money below the AFR (including interest-free loans), the IRS can impute interest—the difference between the AFR and the rate charged—and treat that amount as taxable income to the lender.
• Imputed interest may also be treated as a gift from the lender to the borrower, which can count against the lender’s annual gift tax exclusion.
• Properly applying the AFR helps avoid unexpected income tax reporting and potential gift tax implications.

How the IRS determines AFRs

The IRS bases AFRs on recent market yields for U.S. Treasury and other marketable debt securities. Rates are published monthly and reflect different maturities and compounding conventions. The legal basis for publication is in the Internal Revenue Code.

AFR categories

AFRs are published for three loan-term categories:
– Short-term: loans with terms of three years or less
– Mid-term: loans with terms of four to nine years
– Long-term: loans with terms longer than nine years

Within each category, the IRS may provide rates using different compounding periods (annual, semiannual, quarterly, monthly). Use the rate that matches the loan’s term and the applicable compounding convention.

Practical use and example

Steps to apply the AFR to a private loan:
1. Look up the IRS AFR for the month the loan is made.
2. Choose the AFR matching the loan term (short-, mid-, or long-term).
3. Use the appropriate compounding convention if applicable.
4. Charge at least that rate to avoid imputed interest.

Example:
– You lend $10,000 to a relative for one year. If the short-term AFR were 4.16%, the required interest for the year would be:
– Interest = $10,000 × 4.16% = $416
– If you charge less than $416 in interest (or no interest), the IRS could impute the $416 as income to you and potentially treat the difference as a gift to the borrower.

Tax consequences of below‑market loans

• Imputed interest is generally taxable to the lender as interest income.
• The imputed interest amount may be treated as a gift from lender to borrower and count against the gift tax annual exclusion.
• Failing to follow AFR rules can lead to additional taxes and potential penalties.

Practical tips

• Consult the IRS table for the AFR published in the month you make the loan.
• Put loan terms in writing (amount, interest rate, repayment schedule) and maintain documentation.
• For significant or complex loans, consider consulting a tax advisor or attorney to confirm tax treatment and reporting obligations.

Sources

• Internal Revenue Service — Applicable Federal Rates (AFRs) and related rulings
• Internal Revenue Code — provisions governing the determination and use of AFRs