APPLICABLE FEDERAL RATE (AFR)
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The minimum interest rate you must charge on a loan in order for it to be considered fair market rate for the loan to be considered a taxable event and not a gift by the IRS.
Summary
The Applicable Federal Rate (AFR) is the minimum interest rate set monthly by the IRS that must be charged on private loans to avoid tax consequences. If you lend money at a rate below the AFR, the IRS may treat the difference as a taxable gift to the borrower. The AFR varies based on loan term (short-term: 3 years or less, mid-term: 3-9 years, long-term: over 9 years) and is updated monthly based on federal government borrowing costs. This rate ensures that private loans reflect fair market conditions and prevents people from using below-market loans to transfer wealth without paying gift taxes.
Usage Context
Critical when studying gift and estate tax planning, family business transactions, intrafamily lending strategies, and understanding how the IRS prevents tax avoidance through below-market rate loans.
Common Confusions
- Thinking AFR only applies to business loans when it also affects personal/family loans
- Believing you can charge any interest rate on family loans without tax consequences
- Confusing AFR with prime rate or other commercial lending rates
- Not understanding that AFR varies by loan term length
- Assuming small loans are exempt from AFR requirements
