What is AFR? Guide to Family & Business Loans Using the Applicable Federal Rate

What Is the AFR?

The Applicable Federal Rate (AFR) is the minimum interest rate the IRS allows for private loans, including those between family members or within closely held businesses. The AFR changes monthly and is published by the IRS for three categories of loans based on their term:

• Short-term loans: Up to 3 years.
• Mid-term loans: Over 3 years, up to 9 years.
• Long-term loans: Over 9 years.

Charging less than the AFR on a loan may result in the IRS treating the loan as a gift or as taxable compensation, which could lead to significant tax consequences for both the lender and borrower.

When to Use the AFR?

The AFR should be applied in a variety of scenarios, particularly when loans occur between family members or closely held businesses. Below are common situations where AFR is required:

1. Loans Between Family Members

When a family member loans money to another family member, whether to purchase a home, start a business, or cover personal expenses, the AFR must be charged to ensure the loan is legitimate. If the loan charges less than the AFR, the IRS may consider the difference as a gift, potentially triggering gift tax obligations.

Charging the AFR ensures the loan is recognized as a valid transaction, allowing the borrower to deduct mortgage interest (if applicable) and requiring the lender to report interest income.

2. Loans for Property Transfers

In transactions where one family member or shareholder finances the sale of property to another, such as in intra-family real estate transfers, charging the AFR prevents the IRS from reclassifying the transaction as a gift. This also allows the buyer to deduct mortgage interest if the loan is secured by the property and meets IRS guidelines for home loans.

3. Installment Sales

When a seller finances the sale of property through an installment sale, whether to a family member or closely held business, the AFR must be charged to avoid adverse tax treatment. Charging at least the AFR ensures the seller reports interest income correctly and the buyer can treat the payments as part of a legitimate loan agreement.

4. Loans Between Businesses and Shareholders

In closely held businesses, loans between the business and its shareholders must also adhere to the AFR. If the loan is made at below-market rates, the IRS may reclassify the loan as a dividend or compensation, leading to additional tax burdens. Charging at least the AFR protects both the lender and borrower from these reclassifications.

How to Apply the AFR to Loans?

To comply with IRS rules, the lender must charge at least the AFR applicable to the loan’s term at the time the loan is made. Here’s how to ensure the loan is properly documented and compliant:

• Check the current AFR: The AFR is updated monthly, so check the IRS website for the most current rate before structuring the loan.
• Document the loan: Create a written promissory note that includes the loan amount, interest rate (at least the AFR), repayment schedule, and any collateral if applicable (such as a home or business assets).
• Make interest payments: Ensure that the borrower makes the required interest payments annually (or as specified in the agreement), which are deductible (in the case of qualified mortgage loans) and reportable as income by the lender.

How is the AFR Calculated

The IRS calculates the Applicable Federal Rate (AFR) each month using data from U.S. Treasury securities. These government-issued securities reflect the cost of borrowing for different time periods—short-term (up to 3 years), mid-term (3 to 9 years), and long-term (more than 9 years). By basing AFRs on Treasury yields, the IRS ensures the rates reflect current market conditions while setting a consistent minimum interest rate for private loans. Once published, these rates apply to transactions made during that month, and lenders must use at least the AFR in effect at the time the loan is created.

Example:

Suppose the mid-term AFR for September is 3%. If a parent loans $100,000 to their child for a 5-year term, the IRS requires at least 3% interest to be charged. That means the child would pay $3,000 in annual interest, which the parent must report as taxable income. If the loan were set at only 1%, the IRS could reclassify the missing 2% as a taxable gift, potentially creating gift tax exposure. By charging at least the AFR, both lender and borrower stay compliant and avoid unintended tax consequences.

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Consequences of Not Using the AFR

If a family or business loan is made without charging the AFR, the IRS may treat the loan as something other than a legitimate loan. This could lead to:

• Gift tax consequences: If the loan is considered a gift, the lender may be liable for gift taxes, depending on the size of the loan and other factors.
• Reclassification of the loan: The IRS may reclassify the loan as taxable compensation or a dividend, leading to additional taxes for both the lender and borrower, which may lead to significant penalties and interest.
• Loss of deductions: If the loan is related to a home mortgage, failing to meet the AFR may result in the borrower being unable to deduct mortgage interest on their tax return.

Conclusion

Charging at least the AFR is essential for ensuring that loans between family members and closely held businesses are treated as legitimate by the IRS. Whether you are lending to a family member, financing a property sale, or engaging in a loan with a closely held business, using the AFR protects both parties from potential tax complications and preserves important tax benefits.

ℹ️ Disclaimer: The information provided in this guide is for general informational purposes only and is not intended to serve as legal advice. While we have outlined IRS rules and general tax guidelines, we strongly recommend consulting with an attorney before preparing any loan agreements or entering into financial transactions. Each situation is unique, and professional legal advice is essential to ensure compliance with all applicable laws and regulations. Questions about tax compliance? Talk to a Gelt CPA today to learn more. 

References

IRC §1274 - Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
‍This section provides the rules for determining the interest rate on certain loans, including how to apply the Applicable Federal Rates (AFR) to below-market loans. It's directly relevant to the AFR's application in loans between family members and closely held businesses.
‍IRC §7872 - Treatment of Loans with Below-Market Interest Rates
‍This section deals with the tax treatment of below-market interest loans, including loans between family members. It outlines how the IRS may impute interest and classify the difference between the actual interest charged and the AFR as a gift or compensation.

IRS Publication 550 - Investment Income and Expenses
‍This publication provides guidance on how to handle interest income from loans, including those between family members, as well as how to report the interest income and deductions related to mortgage loans.