What Is the IRS Applicable Federal Rate?
Learn how the IRS Applicable Federal Rate (AFR) establishes the minimum interest for private loans, defining their tax treatment and preventing imputed income liability.
The Applicable Federal Rate (AFR) is a set of minimum interest rates the Internal Revenue Service (IRS) publishes monthly. Its function is to provide a baseline for private loans to ensure they have substance for tax purposes. Any loan between private parties must carry an interest rate at least equal to the AFR to prevent disguising taxable payments or gifts as interest-free loans.
The IRS determines these rates based on the average market yields of U.S. Treasury obligations from the previous month. Tying the AFR to these government securities ensures the rates reflect current economic conditions. This provides an objective measure for a reasonable interest rate and ensures an appropriate amount of interest income is reported.
The Three Tiers of Applicable Federal Rates
The IRS organizes the AFR into three tiers based on the loan’s duration to ensure the minimum interest rate aligns with the debt’s time horizon. This reflects the principle that longer-term debt often carries a different interest rate profile than short-term obligations.
The short-term rate applies to loans with a term of three years or less. The mid-term rate is for loans lasting more than three years but not more than nine years. The long-term rate is designated for any loan with a term extending beyond nine years.
For each tier, the IRS also publishes different rates based on the frequency of interest compounding. The IRS tables provide a specific AFR for each compounding period within the short-, mid-, and long-term categories, such as:
- Monthly
- Quarterly
- Semiannual
- Annual
Key Scenarios Requiring the AFR
The AFR’s application is mandatory in several common financial situations, most frequently for loans between family members. For example, if a parent lends money to a child for a house down payment, the loan must have an interest rate at least equal to the appropriate AFR.
This requirement prevents the loan from being characterized by the IRS as a disguised gift. If a loan’s rate is below the AFR, the IRS can reclassify the foregone interest as a taxable gift from the lender to the borrower, ensuring the transfer is accounted for under gift tax rules.
Another scenario involves seller-financed property sales. When a property owner finances the purchase for the buyer directly, the loan agreement must include an interest rate that meets the AFR minimum.
This rule ensures a portion of the buyer’s payments is treated as interest income for the seller. It prevents a seller from disguising interest payments as part of the sale price to convert ordinary income into a capital gain, which is often taxed at a lower rate.
Locating and Applying the Official Rate
Individuals must use the official rates published monthly by the IRS in a Revenue Ruling. These can be found by visiting the IRS website and searching for “Applicable Federal Rates Revenue Ruling.”
When setting up a term loan, you can use the lowest AFR from a three-month window: the month the loan is made or either of the two preceding months. This “look-back” rule can be advantageous if interest rates have been rising.
The AFR’s application over time depends on the loan type. For a term loan with a specified repayment schedule, the selected rate is locked in for its duration. For a demand loan, which the lender can call due anytime, the AFR is not fixed and fluctuates with the published short-term rate.
Understanding Imputed Interest
Imputed interest is the enforcement mechanism for AFR rules. It is a value the IRS assigns to represent interest income a lender is deemed to have received, even if no interest was paid or the rate was below the AFR.
When a loan’s interest rate is below the required AFR, there are tax consequences for both parties. The lender must calculate the “foregone interest”—the difference between interest due under the AFR and interest actually collected—and report it as taxable income.
The borrower is treated as having paid the imputed interest and may be able to deduct it if the loan was for an allowable purpose, like business or investment. For loans between individuals, the foregone interest is treated as a gift from the lender, which can trigger gift tax reporting if it exceeds the annual exclusion.