What is the 'Applicable Federal Rate - AFR'
The applicable federal rate (AFR) is a group of interest rates published monthly in the United States by the Internal Revenue Service (IRS) for federal income tax purposes. Every month, the IRS publishes these rates in accordance with Section 1274(d) of the Internal Revenue Code. The publication takes the form of a revenue ruling and is available to the public on the IRS website.
BREAKING DOWN 'Applicable Federal Rate - AFR'One of the main uses of the AFR for the IRS is to compare them with the interest on loans between related parties, such as family members. If the interest on a loan is lower than the applicable AFR, it may result in a taxable event for the parties involved.
Three Distinct Rates
The IRS publishes three AFRs: short-term, mid-term and long-term. Short-term AFR rates are determined from the one-month average of the market yields from marketable obligations, such as U.S. government T-bills with maturities of three years or less. Mid-term AFR rates are from obligations of maturities of more than three and up to nine years. Long-term AFR rates are from bonds with maturities of more than nine years.
In July 2016, for example, the annual short-term AFR was 0.71%, the mid-term AFR was 1.43% was and the long-term AFR was 2.18%.
In addition to these basic rates, the rulings in which the AFRs are published contain several other rates that vary according to compounding period (annually, semi-annually, quarterly, monthly) and various other criteria and situations.
Practical Uses of AFR
When preparing to make a loan between related parties, taxpayers should consider two factors to select the correct AFR. The length of the loan should correspond to the AFRs: short-term (three years or less), mid-term (up to nine years) and long-term (more than nine years). Also, the parties must use the AFR that is published by the IRS at the time when the lender initially makes the loan.
If the lender charges interest at a rate that is lower than the proper AFR, the IRS may reassess the lender and add imputed interest to the income to reflect the AFR rather than the actual amount paid by the borrower. Also, if the loan is in excess of the annual gift tax exclusion, it may trigger a taxable event and income taxes may be owed. Depending on the circumstances, the IRS may also assess penalties.