The applicable federal rate (AFR) refers to the minimum interest rate the Internal Revenue Service (IRS) requires for private loans or loans between family members.
Let’s take a closer look at what the AFR is and how it works.
Definition of Applicable Federal Rate
AFRs are the lowest interest rates that the IRS permits for private loans. Every month, the IRS publishes a set of AFRs in Section 1274(d) of the Internal Revenue Code. They are based on data from market yields of marketable debts such as U.S. Treasury bills. In the event the interest rate on a private loan is less than the relevant AFR, the parties involved will face tax consequences.
While traditional commercial loans focus on earning as much interest as possible and reducing the risk of default, private loans are designed to benefit the borrower. The AFR, however, puts a cap on how generous a private loan can be.
- Acronym: AFR
In July 2021, the IRS published an annual short-term AFR of 0.12%, mid-term AFR of 1.00%, and long-term AFR of 2.07%. Let’s say you decide to lend $5,000 to your child who just lost their job. If you want them to pay you back in five years, you’d be required to charge them a minimum interest rate of 1.00% and receive $50.
This is because your loan must adhere to the mid-term AFR. You may face tax implications if you charge no interest rate or an interest rate lower than 1.00%.
How the Applicable Federal Rate Works
If you decide to loan money to a family member, you need to ensure the length of the loan corresponds to the right AFR: short-term (three years or less), mid-term (up to nine years), and long-term (more than nine years).
There won’t be any penalties if you charge above the appropriate AFR. However, if your rate is below it, you’ll be on the hook for taxes.
You may believe you’re doing your family member a favor by giving them an interest-free loan. Doing so, however, may lead to tax consequences.
Types of Applicable Federal Rates
There are three types of AFRs you’ll typically find:
- Short-term AFRs: These AFRs are based on the one-month average of the market yields from marketable debts of three years or less.
- Mid-term AFRs: Mid-term AFRs are rates that come from debts with maturities that range from three to nine years.
- Long-term AFRs: These are bonds with maturities of greater than nine years.
AFRs are typically much lower than the rates commercial lenders charge, so your family member will likely land a better deal on a loan from you.
Private Loans vs. Gifts
If you don’t charge interest on a private loan, the IRS considers it a gift. You’ll have to file the gift-tax form, IRS Form 709, any year in which you gift money or assets that are worth more than the annual exclusion ($15,000 in 2021). However, the IRS will likely only charge you tax on any gifts you made if your total lifetime gifts above annual exclusions total more than $11.7 million.
Tips for Lending Money to Family Members
If you decide to lend money to a relative, the following tips can help you lend wisely.
Document the Agreement
No matter what interest rate you decide to charge a family member when you lend them money, document the terms of the loan. This way, you can prove whether the agreement was a loan or gift and avoid confusion down the road.
Fill Out Form 1040
You’ll need to fill out Form 1040 to report your interest income if your private loan has an interest rate equal to or higher than the applicable AFR.
Forgive the Loan if Necessary
If your family member won’t be able to repay the loan, you may forgive it and consider it a gift. Unless you exceed the lifetime exclusion of $11.7 million, you won’t have to worry about any tax ramifications.
- AFR is the minimum interest rate the IRS allows for private loans.
- The three types of AFRs are short-term, mid-term, and long-term.
- The IRS publishes AFR rates every month.
- While you can charge below the AFR rate when you lend money to a family member, a lower rate may result in tax consequences.