At Kosa Law Office we frequently work with clients who wish to make loans to their children or other family members, often at a reduced interest rate. These loans sometimes involve a verbal arrangement, other times a land contract or a simple promissory note. But when making such loans, most clients are unaware of something called the Applicable Federal Rate (AFR).
What is the AFR?
The Applicable Federal Rate (AFR) is the minimum interest rate prescribed by the Internal Revenue Service for private loans. Loans made with an interest rate lower than the AFR can result in an unintended taxable event for the maker of the loan. The legal authority for the AFR is found in Section 1274(d) of the Internal Revenue Code (26 U.S.C. §1274(d)).
Where can I find the AFR?
Each month the IRS publishes a new revenue ruling which sets forth the AFR for that particular month. The parties to the loan should use the AFR from the revenue ruling that is published during the month the lender is making the loan. These revenue rulings can easily be found by visiting the irs.gov website and searching that site for “applicable federal rate”.
Which AFR do I use When Loaning Money to a Family Member?
Each monthly revenue ruling published by the IRS includes three different categories of AFRs, including the short-term rate, the mid-term rate, and the long-term rate.
The short-term rate should be used for loans of three (3) years or less.
The mid-term rate should be used for loans over three (3) years but less than nine (9) years.
The long-term rate should be used for loans longer than nine (9) years.
The IRS revenue rulings also contain several other variables and circumstances that can affect the AFR, many of which do not apply to a private loan between family members. To ensure that the proper AFR is being used, it is advisable to consult with your accountant or attorney before entering into the loan arrangement.
What if the Interest Rate I Charge is Below the AFR?
If you make a loan and charge an interest rate that is lower than the AFR, it is considered to be a “below-market” loan. By using a rate that is lower than the AFR, you have failed to collect interest that the tax code assumes you should have collected. This is known as “foregone interest”. Even though you did not actually receive this foregone interest, the IRS can treat you as if you had. This is referred to as “imputed interest”, and you must report this as taxable income.
Don’t Fail to Plan
Before making a loan to a family member or friend, first be certain that you are using the proper AFR and that you understand the tax consequences of the transaction. The AFR revenue rulings can be complex, and certain exceptions can apply, so it is advisable to consult with your attorney or accountant about these matters. If you have questions about the Applicable Federal Rate, contact Attorney Stephen Kosa today.