The Internal Revenue Service (IRS) specifies an interest rate that must be charged on private loans or loans between family members. It’s called the applicable federal rate (AFR), and it gets updated monthly. This is the minimum interest rate you must use if you loan money to a friend, a relative, or a business associate. Businesses must also use at least this rate when lending money to each other.
You can charge more than this rate on a private loan, but charging less can lead to income and/or estate tax consequences. This guide explains what the applicable federal rate is and how it works. It also shows you how to find out what rate you need to charge on a private loan and outlines the tax implications of using a lower rate on a private loan. Here is what you need to know about the AFR before issuing a personal loan.
How Applicable Federal Interest Rates Work
When you file your taxes, you may owe taxes to the IRS. The amount of time you have to pay your taxes is called the “statute of limitations.” The statute of limitations for most taxpayers is 10 years from the due date of the return, without regard to extensions. If you do not pay your taxes within that time frame, the IRS may begin to charge you interest on the outstanding balance.
The amount of interest charged by the IRS is called the “applicable federal rate” (AFR). The AFR is a low, variable interest rate set by the IRS. For example, as of October 2020, the AFR for short-term debt is 0.09%, while the AFR for long-term debt is 2.22%.
The IRS updates AFRs every month based on market conditions. There are several types of rates, and the rate you should use depends on the loan term, how often the loan compounds, and a few other factors. You can check out the IRS’s website for the most current rates. Here is some additional detail about how the rates work and how they are adjusted:
Term of the Loan
The rates vary based on the term of the loan. There are short-term rates for loans with up to three-year terms. Mid-term rates apply to loans with terms of more than three years and less than nine years. Long-term rates are for loans with nine-year or longer terms.
Compounding Period
The rate also varies based on the compounding period. Compounding refers to how often you add interest onto interest. The IRS assigns different rates based on the following compounding schedules: annual, semiannual (twice a year), quarterly, and monthly. This is advantageous to private borrowers because many commercial loans, such as mortgages, compound interest daily. The more often you compound, the more interest the lender earns.
Adjusted AFRs
The IRS also publishes a list of adjusted AFRs. These rates vary based on the loan term and its compounding period. The IRS multiplies the AFR by an adjustment factor to get these rates. The adjustment factor is 100% minus the product of a combined tax rate multiplied by a fixed percentage.
The combined tax rate is the maximum individual rate under two sections of the Internal Revenue Code. The fixed percentage expresses a relationship between the current combined tax rate and the spread between yields of taxable and tax-exempt interest.
How Is the AFR Determined?
The AFR is set monthly by the IRS based on market conditions. Specifically, it’s based on rates published by three different government securities dealers.
The AFR for any given month is equal to the average yield of all taxable securities with maturities similar to the length of time that funds are expected to be in a particular account. For example, if you have an IRA that you expect to keep invested for 20 years, then the AFR used to calculate interest on that account will be based on 20-year Treasury securities.
Generally speaking, longer-term rates are higher than shorter-term rates because there’s more risk associated with holding a security for a longer period of time. That’s why you’ll typically earn more interest on a long-term investment than a short-term one.
Long-Term Tax-Exempt Rate for Ownership Changes
The AFR also determines the long-term tax-exempt rate in relation to corporate ownership changes. Corporations that buy or take over other corporations that have been running at a loss must use this rate when calculating how much of the old corporation’s net operating loss they can claim against corporate income on their tax returns.
This rate is the highest adjusted long-term rate of the current month and the two previous months. Here is an example. Say the adjusted long-term rate was 4% in July, 3% in August, 2% in September, and 5% in October. The long-term tax-exempt rate for ownership changes in September will be 4%, and in October, it will be 5%. These calculations can get complicated, and there are a lot of caveats. Consult with a tax professional to ensure you’re using the correct rate.
Section 7520 Rates
The IRS also publishes Section 7520 rates with its monthly AFR updates. These rates apply when you’re determining the present value of an annuity, the interest for life or term insurance, or a remainder or reversionary interest. These aren’t the kinds of issues most individuals or business owners deal with on their own. This is why it’s a good idea to hire an accountant experienced with small businesses, estates, or trusts. They can help you navigate the complexities of the IRS’s rules whether you’re lending money, issuing an annuity, or engaging in estate tax planning.
You need to find the right rate for your situation when providing someone with a private loan. This comes into play, for example, if you lend money to a family member or if your business lends money to another business. You’ll need to use the correct monthly rate when you initiate the loan. You can continue using that rate for the life of the loan. You don’t have to adjust your rate when the applicable federal rate changes.
Tax Implications of the Applicable Federal Rate
The IRS uses the AFR to help ensure people don’t use low- or no-interest loans to get around gift tax laws. It also uses these rates for a variety of business, estate, and trust tax purposes. You must charge at least this rate on private loans, but you can charge more.
The IRS doesn’t set a maximum rate for loans. That is typically set on the state level – if you want to charge a high-interest rate on a private loan, check your state laws to see the maximum rate you can use. Most states have usury laws that define this rate. Here is an analysis of the tax implications of loans with interest rates lower than the applicable federal rate.
How a Low-Interest Loan Becomes a Gift
Giving someone a loan at a very low interest rate may be considered a gift by the IRS. Here is an example. Say you lend your friend $10,000. You decide to charge just 1% in interest that is compounded annually, and your friend agrees to pay you back in two years.
The short-term AFR when you lend the money, however, is 3%. Your actual interest for the first year is $100, but if you had used the short-term AFR, the interest for the first year should have been $300. The IRS considers the difference to be a gift.
The whole loan wasn’t a gift because you will receive back the money, but the interest you didn’t charge on the loan is considered a gift. You’re allowed to give this interest discount as a gift. There is absolutely nothing wrong with that. You can give gifts to whomever you want, whenever you want, but going over the gift tax threshold affects your estate tax limitations. Be aware of how this works before you give away a lot of gifts, whether the gifts are cash or low-interest loans.
When You Need to File a Gift Tax Return
You must file a gift tax return if you give a gift that exceeds the annual gift tax threshold. This is $16,000 for 2022 and $17,000 for 2023. The gift limit usually gets higher based on inflation every year, and it sometimes gets changed by updates to federal tax laws.
Keep in mind you can double this threshold if you give a gift as a married couple. Say, for instance, you and your spouse want to give a gift to your child. You can give them up to $32,000 in 2022 without triggering a filing requirement.
A gift from you and your spouse to your adult child and their spouse could be up to $64,000 in 2022 without triggering a gift tax requirement. This basically means you gave your child $16,000 and you gave their spouse $16,000. Plus, your spouse gave both of them $16,000. The total is higher than the threshold, but none of the individual gifts exceed the threshold, so you don’t need to file a gift tax return.
Going over the gift limit for the year requires you to file a gift tax return. You don’t have to pay any tax when you file that return, luckily. The amount you report, however, gets subtracted from your estate tax exemption when you die.
How Gifts Affect Your Estate Tax Exemption
Here is how your lifetime gifts affect your estate tax exemption. The estate tax exemption is $12.06 million for 2022. Any value in your estate over this threshold incurs estate tax when you die. Say you had $13.06 million at your death. Your estate will pay estate tax on the $1 million that exceeds the threshold.
Now imagine you gave away $2 million in gifts you had to report on gift tax returns. That $2 million gets subtracted from your estate tax exemption, which lowers the exemption to $10.06 million for 2022. Your $13.06 million estate now faces estate tax on $3 million.
You could have, theoretically, given away $2 million (or more) in your life without the gifts affecting your estate tax exemption. You just would have had to give away the $2 million in small gifts that didn’t exceed the gift tax exemption for the year in question. You can also, in that same vein, issue a no- or low-interest private loan without triggering gift or estate tax implications. You just have to ensure the amount the borrower is saving on interest doesn’t exceed the gift tax exemption for the year.
A tax professional can help you navigate these complex situations. They can ensure a loan doesn’t have tax implications for the borrower or the lender. A tax lawyer, in particular, may also be able to help you draft a loan contract.
Pitfalls to Avoid With Private Loans
Helping out a friend, a family member, a colleague, or even another business with a private loan can be a great thing to do. It can also put a little bit of interest in your pocket if you want to make some money. These loans, however, can have unintended tax consequences if not handled correctly. Keep these tips in mind to protect yourself before issuing a private loan:
- Look at the AFR: Research the IRS’s applicable federal rates for the current month and figure out how they apply to your loan.
- Calculate the tax implications of using a lower rate: Make sure you understand the tax implications of using a lower rate and are ready to meet any income or gift tax filing requirements.
- Document the loan: Write up a contract that outlines the loan amount, term, and interest rate so the IRS can’t claim it was a gift.
- Report the interest as income: You should report interest equal to or over the AFR as income on your tax return. Your accountant should be able to tell you if you need to report interest under the AFR.
- Consult a tax specialist: The AFR is complicated, especially for businesses. Talk with a tax professional to ensure you’re not creating any unexpected tax issues.
You can also turn a loan into a gift if needed. The value of the gift is the amount of the forgiven loan plus any interest you didn’t collect because you charged less than the AFR. You, again, only have to report this amount if it is less than the gift tax exemption for the year. You can effectively increase the exemption when you get two or more recipients or givers involved, as explained above.
Get Help From the Silver Tax Group
Our experts at Silver Tax Group understand taxes can be complicated, and we spend all day every day helping our clients navigate the twists and turns of the tax code. Our tax attorneys can help you handle the details of setting up a personal loan. We can also help if you have been audited and the IRS is questioning the terms or rates used on a private loan.
Dealing with the IRS can be time consuming, stressful, and even scary. We can help, regardless of the tax issue you’re facing – to learn more, contact us at the Silver Tax Group today. We’ll leverage our extensive knowledge and experience to help you get the best result possible for your tax issues.
