What Is the Applicable Federal Rate (AFR)?
Applicable Federal Rate (AFR) Definition
The Applicable Federal Rate, or AFR, is the minimum rate of interest that can be charged on private loans without incurring taxes.
If a loan’s interest falls below the Applicable Federal Rate, the loan can trigger a taxable event.
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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.
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.
What Is AFR (Applicable Federal Rate) FAQs
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.