What is AFR (Applicable Federal Rate)?
Applicable Federal Rate (AFR) Definition
If a loan’s interest falls below the Applicable Federal Rate, the loan can trigger a taxable event.
The IRS publishes a document each month which outlines the Federal Short Term Rate for various conditions:
1. Length of loan
There are three Applicable Federal Rates, depending on the length of the loan.
- Short-term — loans of three years or less
- Mid-term — loan terms between three and nine years
- Long-term — loans longer than nine years
Other AFR conditions include:
2. The time frame which the loan compounds
Shorter compounding time frames result in higher annual interest, so the AFR decreases for compounding interest on shorter time frames.
3. Rates for Low-Income Housing Tax Credit, or LIHTC, which are the rates at which low-income households receive a tax credit on the value of their loans.
4. Rate for Valuation of Annuities which is 120% of the annually compounding mid-term Applicable Federal Rate.
5. The Sale-Leaseback Rule and Exceptions which is where an asset is sold and leases it back for use. Exceptions include the sale of small businesses and farms.
Example of Applicable Federal Rates
If the IRS Applicable Federal Rate for a short-term loan is 2.5% and $20,000 is lent for one year, then $500 in interest should be incurred when the loan is repaid.
If less than $500 in interest is charged, the IRS may add imputed interest to the income to reflect the AFR rather than the interest paid by the borrower.
Also, if $20,000 is above the annual gift tax exclusion, income taxes may be incurred on the amount in excess of the annual gift tax exclusion.