Applicable Federal Rate (AFR)

Section 1274(d) of the Internal Revenue Code (IRC) requires the IRS to calculate, and publish, applicable federal rates on a monthly basis. Short-term rates are calculated using the one-month average yield for securities such as treasury bills with maturities of three years or less. Mid-term rates are determined using similar government debt obligations with maturities ranging from greater than three years up to nine years. Finally, long-term rates are established using government bonds with maturities in excess of nine years.

While these rates are used by the IRS for a variety of purposes, the most common application of the rate involves loans to family members. Specifically, the rate of interest charged on a loan must be equal to or higher than the AFR or the transaction is considered a below-market loan, which may result in a taxable event. Lenders need to be aware of two factors when selecting the correct AFR:

• Length of Loan: short-term (three years or less), mid-term (up to nine years), and long-term (more than nine years).

• Timing: the correct AFR to use is the one published by the IRS when the loan is initially made to the borrower.

If the lender fails to charge of rate of interest that is equal to or greater than the applicable federal rate, they may be subject to two penalties:

• Gift Tax: if the loan is in excess of the annual gift tax exclusion, a taxable event is triggered and income taxes may be owed.

• Imputed Interest: the IRS will calculate the difference between the applicable federal rate and the rate of interest charged on the loan. It will then calculate the income taxes owed by the lender on the loan, modeling their income tax return as if the AFR was charged the borrower.

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