Glossary term
Applicable Federal Rate
The applicable federal rate is a monthly IRS-prescribed minimum interest rate used for certain tax calculations, including below-market loans and imputed interest.
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What Is the Applicable Federal Rate?
The applicable federal rate, or AFR, is a set of IRS-prescribed interest rates used for federal income tax purposes. The IRS publishes AFRs monthly in revenue rulings, and the rates are commonly used to test whether certain loans and deferred-payment arrangements have adequate stated interest.
AFRs matter most when money moves between related parties or when a transaction has a financing element. A below-market family loan, shareholder loan, seller-financed sale, private annuity, grantor retained annuity trust, or other tax-sensitive transaction can create imputed interest, gift, income, or valuation consequences if the rate is too low or the wrong rate is used.
Key Takeaways
- The IRS publishes AFRs every month for federal tax purposes.
- AFRs are grouped by term: short-term, mid-term, and long-term.
- The rates can be stated with annual, semiannual, quarterly, or monthly compounding.
- Below-market loans may trigger imputed interest or gift-tax consequences.
- The correct AFR depends on the month, loan term, compounding convention, and transaction type.
How AFRs Work
AFRs are organized by the length of the obligation. Short-term rates apply to obligations of three years or less. Mid-term rates apply to obligations of more than three years and not more than nine years. Long-term rates apply to obligations longer than nine years.
For example, if a parent lends an adult child money for eight years, the mid-term AFR for the month the loan is made is usually the relevant starting point. If the loan charges less than the required rate, tax rules may treat part of the arrangement as if interest had been paid or as if a gift had been made, even if no cash interest actually changed hands.
Where It Shows Up
AFRs show up in intrafamily loans, installment sales, private business financing, shareholder advances, employer-employee loans, estate planning transactions, and certain debt instruments. They also interact with other tax reference rates, including the Section 7520 rate used in several valuation contexts.
Loan documents should state the interest rate, repayment terms, compounding convention, maturity, collateral if any, and payment schedule. A real loan should also be administered like a real loan: payments should be tracked, interest should be reported when required, and modifications should be documented.
What to Watch
The AFR is not one static number. It changes monthly, and different tables within the IRS revenue ruling may serve different tax purposes. Pulling an old rate from a search result can quietly create a problem if the loan is made in a different month or has a different term.
The rate is also a tax floor, not necessarily a market rate. A loan that satisfies AFR rules may still be economically risky, poorly documented, or unattractive compared with commercial financing.
The Bottom Line
The applicable federal rate is the IRS benchmark that keeps certain private loans and financing arrangements from being treated as interest-free for tax purposes. It is a small number with large consequences, so the correct month, term, and compounding basis matter.