How IRC Section 1274(d) Determines the Applicable Federal Rate

Internal Revenue Code (IRC) Section 1274 addresses the tax implications of debt instruments issued for property, targeting transactions with unstated or understated interest. To prevent parties from disguising interest income as a capital gain, this provision requires seller-financed loans to carry a sufficient interest rate. Subsection (d) establishes the Applicable Federal Rate (AFR) as the benchmark for determining if a loan’s interest rate is adequate. This article explores how this rule functions, from defining the AFR to its application and exceptions.

Understanding the Applicable Federal Rate (AFR)

The Applicable Federal Rate (AFR) is a set of minimum interest rates published monthly by the Internal Revenue Service (IRS). These rates are a tool to prevent tax avoidance in seller-financed property sales. Without such a floor, a seller could offer a loan with a below-market interest rate for a higher purchase price, improperly converting ordinary interest income into a capital gain.

The IRS determines AFRs based on the average market yields of outstanding U.S. government debt, publishing them monthly in a Revenue Ruling. This structure ensures the minimum interest rate reflects the current economic environment. The rates are categorized based on the term of the associated debt instrument.

The rates are divided into three categories based on the loan’s term. The short-term AFR applies to debt instruments with a term of three years or less. The mid-term AFR is used for debt with a term of more than three years but not more than nine years. The long-term AFR is the benchmark for any debt with a term exceeding nine years.

Determining the Correct Test Rate for a Transaction

Selecting the correct AFR for a transaction is a multi-step process. The first step is to determine the term of the debt instrument, which dictates whether the short-term, mid-term, or long-term rate applies. For example, a five-year owner-financed mortgage would fall under the mid-term category, while a 15-year note would use the long-term rate.

A provision within the code, the “3-month lookback rule,” offers flexibility. This rule permits using the lowest AFR in effect for any month within the three-calendar-month period ending with the first month a binding written contract is established. If a contract is signed in May, the parties can use the lowest applicable AFR from March, April, or May. This can be advantageous in a rising interest rate environment.

Parties must also select the rate that corresponds to the compounding period specified in the debt instrument. The IRS publishes AFRs for annual, semiannual, quarterly, and monthly compounding. To ensure an accurate comparison, the compounding frequency of the chosen AFR must match the compounding frequency of the interest stated in the loan agreement.

Application of the AFR and Original Issue Discount (OID)

Once the correct AFR, or “test rate,” is determined, it is compared to the stated interest rate in the debt instrument. If the stated rate is equal to or greater than the test rate, the loan has adequate stated interest. However, if the stated interest rate is lower than the test rate, the loan has inadequate stated interest, which triggers the Original Issue Discount (OID) rules.

OID is a form of phantom interest. It represents the difference between the loan’s stated redemption price at maturity (the principal) and its issue price. When a loan has inadequate stated interest, the issue price is re-calculated by discounting all payments due under the loan using the AFR as the discount rate. This newly calculated, lower issue price creates a “discount,” which is treated as additional interest for tax purposes.

The tax consequences of OID affect both the lender and the borrower. The lender (seller) must include the OID in their taxable income over the life of the loan, even though they are not receiving corresponding cash payments. Conversely, the borrower is entitled to an interest expense deduction for the accrued OID over the same period. These rules place both parties on an accrual basis of accounting for the phantom interest.

For instance, consider a sale of property for a $500,000 note due in five years with a 2% interest rate, when the applicable mid-term AFR is 4%. Because 2% is less than the 4% test rate, the OID rules apply. The issue price of the note is recalculated by discounting the future payments at the 4% AFR, resulting in an issue price lower than $500,000. The difference is the OID, which must be reported as income by the seller and can be deducted as an expense by the buyer over the note’s term.

Exceptions and Special Rules

Several specific exceptions exist for transactions where the potential for tax abuse is considered low or where applying these complex rules would be overly burdensome. If a transaction falls within one of them, the parties are not required to test the interest rate against the AFR. Instead, the simpler rules of IRC Section 483 may apply, or there may be no imputed interest requirement at all.

Common exceptions include the following transactions:

• The sale of a farm by an individual, family, or small partnership for a price of $1 million or less.
• The sale of a principal residence, regardless of the sales price.
• Any sale or exchange of property where the sum of all payments due does not exceed $250,000.
• Certain land transfers between related individuals, which are governed by alternative rules.
• Debt instruments where all payments are due within six months of the sale.