What is the Applicable Federal Rate (AFR)?
– Definition: The Applicable Federal Rate (AFR) is the minimum interest rate the U.S. tax code requires on certain private loans. The IRS publishes AFRs each month so lenders and borrowers can see the baseline rate the government expects for family loans, sales of installment obligations, and similar transactions.
How the IRS sets the AFR
– The U.S. Treasury looks at market yields on government debt of various maturities and the IRS converts those market signals into published AFRs. The rates are released monthly under rules in the Internal Revenue Code (including Section 1274(d)). AFRs are presented for different loan terms and for different compounding conventions (annual, semiannual, quarterly, monthly).
Types of AFRs
– Short-term AFR: loans with terms of 3 years or less.
– Mid-term AFR: loans with terms of more than 3 years up to 9 years.
– Long-term AFR: loans with terms longer than 9 years.
– For each term group the IRS normally gives several rates reflecting different compounding frequencies; use the rate that matches how interest on your loan will be computed.
Why the AFR matters (brief)
– If you lend money below the applicable AFR, tax rules may treat the difference as imputed interest. That imputed interest can create taxable income for the lender and may count as a gift from the lender to the borrower (which could use part of the lender’s annual gift exclusion or trigger gift-tax reporting). Failing to follow AFR rules can lead to additional taxes or penalties.
How to use the AFR when you make a private loan (step-by-step)
1. Determine the loan origination month. Use the AFR table published for that month.
2. Classify the loan term: short (≤3 years), mid (>3 ≤9 years), or long (>9 years).
3. Choose the compounding convention that matches your loan agreement (annual, monthly, etc.).
4. Find the corresponding AFR from the IRS table for that month and term.
5. Calculate the required interest using the chosen compounding method. If you want simplicity, you can use simple annual interest if that matches the loan terms, but be consistent with the compounding the AFR reflects.
6. Document the loan (promissory note) showing principal, term, interest rate, payment schedule, and compounding method.
7. Report income correctly for tax purposes and consult a tax professional if there’s any doubt.
Short checklist before lending to family or friends
– Check the AFR table for the month you make the loan.
– Match term (short/mid/long) and compounding frequency.
– Put the loan terms in writing (rate, schedule, security if any).
– Charge at least the AFR (or be prepared to report imputed interest and possible gift implications).
– Keep records of payments and tax reporting forms.
– Consult a tax adviser when the loan amount or terms are material.
Worked numeric example
Assumptions:
– Loan principal: $10,000
– Term: 1 year (short-term)
– AFR (example month): 4.16% annual (annual compounding)
Simple annual interest calculation:
– Interest = Principal × Rate = $10,000 × 0.0416 = $416
– Amount due at year-end = $10,000 + $416 = $10,416
Notes on this example:
– The calculation above uses simple annual interest consistent with an annual compounding rate. If your loan uses monthly or quarterly compounding, calculate using the appropriate formula for periodic compounding.
– If you charge less than the AFR, the IRS may treat the $416 (or the difference between the AFR interest and charged interest) as taxable income to you and potentially as a gift to the borrower.
Important assumptions and caveats
– AFRs and tax consequences can be technical. The precise effect (imputed interest treatment, gift-tax consequences, reporting requirements) depends on loan structure, whether payments are made, whether the loan is secured, and other facts.
– The IRS updates AFRs monthly; always use the table for the correct month.
– This explainer gives general educational information, not tax or investment advice.
Reputable sources
– Internal Revenue Service — Applicable Federal Rates (AFRs): https://www.irs.gov/applicable-federal-rates
– Internal Revenue Service — Gift Tax: https://www.irs.gov/businesses/small-businesses-self-employed/gift-tax
– U.S. Department of the Treasury — Interest Rate Statistics / Treasury interest-rate data: https://home.treasury.gov/resource-center/data-chart-center/interest-rates
– Investopedia — Applicable Federal Rate (AFR): https://www.investopedia.com/terms/a/applicablefederalrate.asp
Educational disclaimer
This information
is provided for general educational purposes only and does not constitute tax, legal, or investment advice. For transactions that may have tax, gift-tax, estate-tax, or legal consequences, consult a qualified tax professional or attorney who can apply the law to your facts.
Practical checklist — using AFRs correctly
– Identify the loan type and term. IRS Applicable Federal Rates (AFRs) are categorized by term:
– Short-term: ≤ 3 years
– Mid-term: > 3 years and ≤ 9 years
– Long-term: > 9 years
– Get the correct monthly AFR table from the IRS for the month in which the loan is issued. The IRS posts separate rates for different compounding conventions (annual, semiannual, quarterly, monthly) — use the one the IRS requires for your situation.
– Determine whether the loan is a demand loan (no fixed term), a term loan (fixed term, scheduled payments), or an installment loan (regular payments toward principal and interest).
– Check Section 7872 thresholds and exceptions:
– Small loans (de minimis) typically under $10,000 are often exempt from imputed interest rules.
– Loans between roughly $10,000 and $100,000 have limited imputation rules that depend on the borrower’s net investment income.
– Loans above $100,000 are generally subject to full imputation rules. (Because interpretations can change, confirm current thresholds and rules with a tax pro or the IRS.)
– Compute imputed interest and tax consequences. If the AFR exceeds the stated rate, the IRS may impute (treat as if) interest equal to that AFR.
– Report income or gifts appropriately: lenders generally report imputed interest as interest income; imputed interest in excess of actual interest paid may be treated as a gift from lender to borrower for gift-tax purposes if it meets the gift-tax definition.
– Keep documentation: loan agreement, payment history, calculations using the AFR, and advice from tax counsel.
Step-by-step worked examples (numeric)
Example A — Simple 1-year interest-free loan (demand-style or short-term)
– Facts: Lender loans $10,000 to borrower; loan states 0% interest; 1-year term. IRS short-term AFR for the month of issue = 1.5% (annual).
– Imputed interest for the year = principal × AFR = $10,000 × 0.015 = $150.
– Practical effect: The lender may need to report $150 as interest income; the borrower may be treated as having received a $150 gift if the lender is treated as foregoing interest (check gift-tax rules and exclusions).
Example B — 5-year amortizing loan with no stated interest (mid-term)
– Facts: Principal P = $50,000; term n = 5 years; assume mid-term AFR (annual rate) = 2.0% (0.02). We’ll compute level annual payments that amortize principal at rate r = 0.02.
– Annual payment formula (standard annuity): Payment = r × P / (1 − (1 + r)^−n)
– Compute: (1 + r)^−n = (1.02)^−5 ≈ 0.90573
– Denominator = 1 − 0.90573 = 0.09427
– Numerator = 0.02 × 50,000 = 1,000
– Payment ≈ 1,000 / 0.09427 ≈ $