Understanding the AFR: The Rate Every Family Loan Needs

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The Applicable Federal Rate is the minimum interest a family loan should charge to stay clean with the IRS.

Every intra-family loan has a minimum interest rate attached to it by law. Charge less, and the IRS does not simply ignore the shortfall. It invents the interest you should have charged and taxes you on it. That minimum is the Applicable Federal Rate.

What the AFR actually is

The AFR is a set of interest rates the IRS publishes every month under Section 1274(d) of the tax code, derived from yields on US Treasury obligations. During each calendar month the IRS determines and publishes the rates that apply for the following month.

There are three tiers, chosen by the term of the loan:

• Short-term: loans maturing in three years or less
• Mid-term: loans maturing in more than three years but not more than nine
• Long-term: loans maturing in more than nine years

Each tier is published with annual, semiannual, quarterly and monthly compounding variants. You use the one matching how your loan actually compounds.

What happens if you charge less

Section 7872 governs below-market loans. If a family loan charges less than the AFR, the difference between what you charged and what the AFR would have produced is called forgone interest, and the IRS treats it as though it really moved.

For a family loan, that means two simultaneous fictions:

• The lender is treated as having received that interest, and owes income tax on it, on money never actually collected.
• The lender is then treated as having gifted the same amount back to the borrower, which counts against the annual gift-tax exclusion.

This is the trap that catches well-meaning families. A zero-interest loan feels like the generous choice. In tax terms it can be the expensive one, because it generates phantom income for the lender every year the loan is outstanding.

The exceptions worth knowing

Section 7872 contains relief for small loans. There is a $10,000 de minimis threshold below which gift loans between individuals generally escape the imputed-interest rules, provided the loan is not attributable to income-producing assets.

There is also a $100,000 threshold. For gift loans between individuals at or below that amount, imputed interest is generally limited to the borrower's net investment income for the year, and if that income is $1,000 or less it can be treated as zero.

These exceptions are genuinely useful, and they are also where families most often over-rely on half-remembered advice. The conditions matter, and they turn on facts specific to the loan and the borrower.

Why using the AFR is usually the better deal anyway

Families often assume charging interest makes the arrangement less generous. Run the numbers and the opposite is generally true.

The AFR tracks Treasury yields, which means it is almost always dramatically below what a retail lender would charge for the same borrowing. A mid-term AFR on an intra-family loan for a car, a business or a bridge is typically a fraction of a personal-loan or credit-card rate. The borrower still wins substantially. Meanwhile the lender earns a real return on capital that was often sitting in cash, and the interest stays inside the family instead of leaking to an institution.

Charging the AFR also does something subtler: it makes the loan unambiguously a loan. That protects the arrangement from being recharacterized as a gift, which is the single most common failure mode in family lending.

Getting it right in practice

Three habits cover most of the risk:

• Lock the rate at origination. The AFR that matters is the one in effect when the loan is made. Later movements do not retroactively break a properly documented loan.
• Match the tier to the real term. A ten-year loan documented at the short-term rate is an invitation to scrutiny.
• Write it down and actually service it. A rate on paper with no repayments behind it does not look like a loan to anyone reviewing it later. See how to document a family loan the IRS will respect.

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General information, not tax or legal advice. Section 7872 and the AFR rules turn on specific facts, and thresholds can change. Confirm the details with your own tax adviser.