Alternate name: Applicable Federal RateAcronym: AFR
When a large sum of money passes hands between friends or relatives, the IRS will consider the money either a loan or a gift depending on its value and if interest is charged. Generally, the IRS looks to see minimum-interest rules applied to family loans of $10,000 or more. If the loan is less than that, you may not have to worry about tax implications. For example, let’s say you give your adult child $15,000 to put toward a down payment on a home in August 2021. Your child has agreed to repay the money within one year, making it a short-term loan according to minimum-interest rules. You could charge your child the August 2021 AFR rate, which would make them pay 0.19% interest on the $15,000, or $28.50. Deducting the AFR from the principal, the value of the loan is now $14,971.50. The amount falls under the IRS’s annual gift tax exclusion of $15,000 in 2021 (increasing to $16,000 in 2022) so it’s not considered a gift. Also, since interest was charged, it is considered a loan. If the parent gave $17,000, and did not charge interest, it would be considered a gift, and the parent may have to pay the gift tax.
How Minimum-Interest Rules Work
The minimum-interest rules rates are determined by a few different economic factors. For example, the prior 30-day average market yields of corresponding U.S. Treasury obligations (such as T-bills, treasury bills sold at discount rates that mature) are taken into account when determining the most recent AFR. With family loans, particularly loans more than $10,000, the AFR represents the absolute minimum interest rate you should consider charging. By charging the correct minimum amount of interest, you can avoid unnecessary tax complications. When it comes to family loans, three AFR tiers come into play: You may also want to note the length of the loan’s agreed-upon repayment, and what the AFR is for that repayment term during the month in which you make the loan. Because AFRs change on a monthly basis, it’s best to use the AFR that is in place when the loan is established. As long as you meet or surpass that AFR, you’ll be good to go, as that rate is locked in for the life of your loan.
What It Means for Your Family
The IRS doesn’t want you making interest-free loans of substantial amounts to your family; because of this, it will tax you if you do not adhere to the minimum-interest rules. If you choose not to charge a family member interest that is at least equal to the AFR, the IRS may tax you on the difference between the AFR and the interest rate actually charged. If the loan’s borrower uses the money to generate income (like investments or making a profit), you will need to report the interest income on your taxes, too. Remember, loaning money to family doesn’t just involve writing a check and agreeing to a loose repayment plan. The IRS requires loans between family members to be handled a certain way. You and your family member should sign a written agreement, keep a fixed repayment schedule, and set a minimum interest rate for the loan.
