What Is the Applicable Federal Rate (AFR)?
The lowest interest rate that the Internal Revenue Service (IRS) permits for private loans is known as the applicable federal rate (AFR). The IRS releases a list of interest rates every month that the organization views as the minimal market rate for loans. If the interest rate is lower than the AFR, there will be tax consequences. In compliance with Internal Revenue Code Section 1274(d), the IRS publishes these rates.
- For the parties concerned, there may be a taxable event if the interest rate on a loan is less than the applicable AFR.
- The original issue discount, unstated interest, gift tax, and income tax implications of below-market loans are calculated using AFRs.
- When the lender first makes the loan, the parties are required to use the AFR that is released by the IRS.
Understanding the Applicable Federal Rate (AFR)
The IRS compares the AFR to the interest paid on loans made between family members and other related parties. Making sure the interest rate on a loan to a family member is at least as high as the federal minimum rate would be necessary if you were providing one.
The IRS publishes three AFRs: short-term, mid-term, and long-term. The one-month average of the market yields from marketable obligations, such as U.S. obligations, is used to calculate short-term AFR rates. S. government T-bills with maturities of three years or less. Mid-term annual percentage rate (AFR) is derived from obligations with maturities ranging from three to nine years. Bonds with maturities longer than nine years are the source of long-term AFR rates.
Apart from the trio of fundamental rates, the decisions wherein the AFRs are released incorporate multiple additional rates that differ based on the compounding period (annual, semi-annual, quarterly, and monthly) as well as diverse other factors and circumstances.
Example of How to Use the AFR
The IRS reported that the annual short-term AFR was 4 as of May 2023. 30%, the mid-term AFR was 3. 57%, and the long-term AFR was 3. 72%. Please remember that the IRS has the authority to modify these AFR rates.
The amount of time allotted for repayment would determine which AFR rate to apply to a family loan. Let’s say you were to lend $10,000 to a relative, with repayment due in a year. The borrower would have to pay you a minimum interest rate of 4. 30% for the loan. Put differently, the loan should yield $430 in interest for you.
In our example above, any rate below 4. 30% could trigger a taxable event. As an illustration, suppose you provided the same loan but waived the interest. You would have “foregone” $430 in interest income by not charging any interest, and the IRS would have deemed it a taxable gift. Foregone interest would be taxable if the interest rate charged for the loan’s specific term was less than the declared annual percentage rate.
Special Considerations
Taxpayers should take into account two factors when planning a loan between related parties in order to determine the appropriate AFR. The loan’s duration ought to line up with the AFRs: short-term, which is three years or less, mid-term, which is up to nine years, and long-term, which is more than nine years.
The IRS may reevaluate the lender and add imputed interest to the income to reflect the AFR rather than the actual amount paid by the borrower if the lender charges interest at a rate lower than the appropriate AFR. Furthermore, if the loan exceeds the yearly gift tax exclusion, it might cause a taxable event and result in the need to pay income taxes. Depending on the circumstances, the IRS may also assess penalties.
Am I Required to Charge Interest When Loaning Money to Family?
No, youre not required to charge interest. But if you don’t, the IRS might view your loan as a gift and charge you taxes appropriately.
How Often Is the AFR Determined?
Every month, the AFR is released with updated interest rates that are determined by the market.
Does My Loan Agreement With a Family Member Have to Be Notarized?
No. Even though notarization could advance it, your signed and written agreement is already enforceable.
The Bottom Line
The applicable federal rate serves as a benchmark for defining what constitutes a loan and what does not. Before you lend money to anyone, make sure to check this rate. If you charge less than this benchmark, you might have to pay gift taxes. Article Sources: Investopedia mandates that authors cite original sources to bolster their claims. These consist of government data, original reporting, white papers, and conversations with professionals in the field. When appropriate, we also cite original research from other respectable publishers. You can read more about the guidelines we adhere to when creating impartial, truthful content in our
FAQ
Which AFR rate to use for family loan 2023?
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Feb. 2024
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Dec. 2023
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Annual
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4.18%
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5.03%
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How to use AFR for family loan?
For an intrafamily loan to avoid being regarded as a taxable gift, the interest rate must be at least as high as the AFR. Depending on the length of the loan, the IRS publishes the AFR for each month on or around the 20th day of the previous month. It is divided into three tiers.
What interest rate can I charge a family member?
6 Assume you were to lend $10,000 to a relative, with repayment due in a year. The borrower would have to pay you a minimum interest rate of 4. 30% for the loan. Put differently, the loan should yield $430 in interest for you. In our example above, any rate below 4. 30% could trigger a taxable event.
How do I know which AFR rate to use?
Calculation of AFR: Based on the loan’s term, there are three different rates that are calculated: Short-term: Less than three years Mid-term: 3 to 9 years. Long-term: Greater than 9 years.
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