What is AFR (Applicable Federal Rates)? And How does it …

If you are like most of the wealthy clients we work with, you have built a great nest egg. With that comes family and friends asking for money or asking for a loan. You want to help out, but you want to make sure you do it the right way. A key aspect often overlooked is the Applicable Federal Rate (AFR), which plays a pivotal role in these transactions. In this post, we’ll dive into what AFR is, its current rates (Short-term: 5.26%, Mid-term: 4.82%, Long-term: 5.03% – go to the IRS website to see the current rates as you read this), and its implications on personal loans.

What is the Applicable Federal Rate (AFR)?

The Applicable Federal Rate (AFR) is a series of interest rates set by the Internal Revenue Service (IRS) monthly. These rates determine the minimum interest that must be charged on private loans to avoid unwanted tax consequences. The AFR rates are based on the average market yields of U.S. Treasury securities and are categorized into three groups based on the duration of the loan: short-term, mid-term, and long-term.

Short-Term AFR

• Duration: Loans with a term of three years or less.
• Current Rate: 5.26%.
• Usage: Ideal for smaller, personal loans or bridge loans.

Mid-Term AFR

• Duration: Loans with a term more than three years but not more than nine years.
• Current Rate: 4.82%.
• Usage: Suited for larger personal loans, such as for a car or major home renovations.

Long-Term AFR

• Duration: Loans with a term more than nine years.
• Current Rate: 5.03%.
• Usage: Often used for significant loans, like mortgages or extensive financial assistance.

Why is AFR Important in Personal Loans?

When loaning money to friends or family, it’s tempting to offer a low or zero interest rate. However, the IRS views such loans with below-AFR interest rates as a gift, potentially subjecting the lender to gift taxes and other complications. Utilizing the AFR ensures compliance with tax laws and fair treatment for both parties.

Tax Implications

For the Lender

If a loan is made at an interest rate below the AFR, the IRS may impute the interest difference and tax it as if it were income. Additionally, the interest not charged could be considered a gift, leading to potential gift tax liabilities.

For the Borrower

The borrower may not face direct tax implications unless the low-interest loan is considered a gift. In that case, it could impact their annual gift tax exclusion limit.

How to Apply AFR in Personal Loans

1. Determine the Loan Term: Assess whether the loan is short-term, mid-term, or long-term.
2. Set the Interest Rate: Use the current AFR for the determined term as the minimum interest rate.
3. Document the Loan: Create a formal loan agreement detailing the loan amount, interest rate, repayment schedule, and other relevant terms.
4. Comply with Tax Requirements: Report any interest income on your tax returns.

Benefits of Using AFR

• Legal Protection: A formal agreement with AFR rates can prevent misunderstandings.
• Tax Compliance: Ensures adherence to IRS regulations, avoiding potential penalties.
• Fairness: Provides a fair, market-based interest rate for both parties.

Conclusion

In conclusion, when loaning money to friends or family, it’s not just about generosity, but also about financial prudence. Understanding and applying the Applicable Federal Rates can ensure that these personal loans are beneficial, compliant, and fair for both parties involved. Whether it’s a short, mid, or long-term loan, adhering to the AFR not only keeps you in line with IRS regulations but also adds a layer of professionalism and fairness to personal financial transactions.

If you have any questions about this or any other financial topic, feel free to reach out to Stephen – stephen@millswealthadvisors.com.