What is the Applicable Federal Rate for Private Loans?

The applicable federal rate (AFR) refers to the minimum interest rate that is permissible on private loans by the Internal Revenue Service (IRS). AFR serves as the minimum market rate for loans and is published by the IRS every month. Every lender is expected not to charge an interest rate below the applicable federal rate. An interest rate below the AFR benchmark is defiant of the IRS regulation and subject to tax implications.

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How Does the Applicable Federal Rate Work?

Section 1274(d) of the Internal Revenue Code gave provision for the applicable federal rate, it is the interest rate allowable for private loans. Private lenders can charge above the AFR but are not permitted to charge below. Through the AFR, the IRS is able to compare the interest rate charged on loans by different parties in the market. Also, when family members or related parties are involved in a loan transaction, they must not charge an interest rate that falls short of the AFR. For instance, if you give a loan to your sister or mother, you are required to charge the AFR or an interest rate a little above and not below.

Three Distinct Rates

There are three categories of the applicable federal rate (AFR) that the IRS publishes every month, these are the short-term AFR rates, mid-term and long-term AFR rates. Short-term AFR rate is charged on loans with a maturity period of three years or less, while the mid-term AFR rate is charged on a loan with a maturity period of between three years and nine years. The long-term AFR rates are applicable to loans with maturities of more than nine years.

Key Takeaways

Here are some important things about the applicable federal rate (AFR);

• AFR refers to the minimum interest rate that can be charged on private loans as stipulated by the Internal Revenue Service.
• There are three categories of AFR rates published by the IRS every month, these are the short-term, mid-term and long-term AFR rates.
• Other factors that the IRS considers when publishing the AFR rates are the compounding periods of the loans which can be monthly, quarterly, semi-annually and annually.
• Lenders can charge above the AFR rates but not below.

When lenders charge below the AFR rate, there are tax implications faced by both parties.

Example of How to Use the Applicable Federal Rate (AFR)

In 2019, the Internal Revenue Service published an applicable federal rate of 2.72%, 2.89%, and 3.15% as short-term, mid-term and long-term AFR rates respectively. If a party is issuing a loan to a family member, for instance, lets say a $50,000 for four years, the mid-term AFR rate will be applied. If the loan is for a period of three years or less, 2.72% or more will be charged as the interest rate. If an interest rate below the AFR rate is charged, both parties are exposed to tax implications. The IRS makes changes to the AFR rate given specific considerations.

Practical Uses of AFR

The applicable federal rates are used by the IRS to monitor the market compliance with the published interest rates. Parties in a loan agreement must consider the length and maturity of a loan so as to select the corresponding AFR rate. The IRS also uses the AFR rates to determine the original issue discount, unstated interest, and income tax implications that will be meted out to interest rates below the AFR rates. In real-life situations, the parties in a loan agreement must adhere to the AFR published by the IRS. A lender that charge interest at a rate lower than the published AFR faces tax implications or any other penalties as determined by the IRS and the level of defiance from AFR.