Applicable Federal Rate (AFR)
Candlefocus EditorThe Applicable Federal Rate (AFR) is a periodic rate of interest set by the Internal Revenue Service (IRS) as the minimum interest rate that must be charged to two or more parties for a loan to avoid it from being considered a taxable event. AFRs are used to determine the original issue discount, unstated interest, gift tax, and income tax consequences of below-market loans. If a loan carries interest that is lower than the prevailing AFR, then it is considered a below-market loan and could result in a taxable event for both parties.
When it Comes to AFRs
For situations when parties make a loan, they must use the AFR that is published by the IRS at the time when the loan is initially made. It’s important to note that AFRs change. According to the IRS, these changes occur when one month ends and another begins. For example, the AFR that is effective for January 2021 could be different from the AFR that is in effect for February 2021.
The purpose of the AFR is to simplify loan agreements between parties and reduce the paperwork associated with these types of loans. It is also designed to prevent taxpayers from avoiding taxes through the use of below-market loans.
AFRs and Tax Avoidance
If a loan agreement has an interest rate that is lower than the AFR, the IRS considers the loan to be a below-market loan and subjects it to taxes. The IRS taxes the interest income that is forgone due to the below-market rates as income even if nothing is received by the borrower. Similarly, if the lender forgives interest income due to the low-interest rate, then the lender must pay taxes on the forgone income.
For tax purposes, the IRS considers interest income that is below the AFR to be a tax-exempt transaction. Interest income earned on a loan with an interest rate that is equal to or greater than the AFR is tax-deductible.
Noting AFRs and Gift Tax
AFRs also come into play with gift tax returns for individuals and corporations. In situations when a loan is conceded or gifted to someone else, the IRS may assess a gift tax if the loan interest rate is lower than the AFR. If the loan interest rate is equal to or greater than the AFR, the transaction is considered tax-exempt.
The Bottom Line
The applicable federal rate is a periodic rate of interest established by the IRS as the minimum interest rate for loans to avoid it from becoming a taxable event for both parties. It’s important for businesses and individuals to understand the implications of AFRs and adhere to these rates if they wish to avoid any punitive taxes.