The term applicable federal rate is used to describe rates published by the Internal Revenue Service (IRS) that are used for a variety of purposes, including assigned interest charges on loans. The applicable federal rate, or AFR, is published monthly by the IRS, and effectively establishes the minimum interest rate that can be charged on a loan.
Section 1274(d) of the Internal Revenue Code (IRC) requires the IRS to calculate, and publish, applicable federal rates on a monthly basis. Short-term rates are calculated using the one-month average yield for securities such as treasury bills with maturities of three years or less. Mid-term rates are determined using similar government debt obligations with maturities ranging from greater than three years up to nine years. Finally, long-term rates are established using government bonds with maturities in excess of nine years.
While these rates are used by the IRS for a variety of purposes, the most common application of the rate involves loans to family members. Specifically, the rate of interest charged on a loan must be equal to or higher than the AFR or the transaction is considered a below-market loan, which may result in a taxable event. Lenders need to be aware of two factors when selecting the correct AFR:
If the lender fails to charge of rate of interest that is equal to or greater than the applicable federal rate, they may be subject to two penalties: