Definition of Applicable Federal Rate
If you were to give a friend an interest-free loan, you might think of it as nothing more than a favor. Under the federal tax code, however, you may actually be giving that friend a taxable gift. But if you charge her a certain minimum rate of interest, there's no problem. That minimum rate is the applicable federal rate.
Say that to get a one-year loan for $20,000 from a commercial lender, someone would have to pay an interest rate of 5 percent, or $1,000. If you were to give that same person a no-interest loan for the same amount, you'd collect no interest, so you'd be essentially giving up $1,000 worth of interest. If you loaned the money at 1 percent, you'd collect $200, so you'd be giving up $800 in interest. The interest you don't collect when you lend money below market rates is what the tax code calls "forgone interest," and the law considers it a taxable gift from you to the borrower. Responsibility for taxes on gifts doesn't lie with the recipient; it lies with the giver -- in this case, you.
Applicable Federal Rates
Every month, the Internal Revenue Service publishes a schedule of the minimum annual interest rate that must be charged for a loan to be considered a market-rate loan and therefore free of tax complications. These are the applicable federal rates, or AFR. These rates are based on market yields on various securities and are typically lower than what a commercial lender would charge. The rates fall into three tiers based on the length of the loan. In mid-2013, for example, the AFR for loans of less than three years was 0.23 percent; for loans of three to nine years, it was 1.22 percent; and for loans longer than nine years, it was about 2.8 percent.
When a lender charges less than the applicable federal rate for a loan, the difference between the actual rate and the AFR becomes "imputed interest," which is taxable to the lender. Say the AFR for a one-year loan is 0.23 percent, and you give someone a one-year loan for $100,000 at 0.1 percent interest. If you charged the AFR, you would be getting $230 in interest, rather than the $100 you're getting on your 0.1 percent rate. The difference of $130 is imputed interest, and you must report it as taxable income, along with the $100 in actual income.
The rules for below-market-rate loans not only apply to loans between individuals -- friends, family members, business partners -- but also to loans between employers and employees or corporations and shareholders. There is one general exception: Loans between individuals of $10,000 or less are not subject to the AFR rules. These loans can be for less than AFR or even for no interest at all.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.