The IRS publishes each month the Applicable Federal Rates (AFR). They just published the rates for September in Revenue Ruling 2011-20. These rates are broken down into three different terms:
- Short-term (less than 3 years)
- Mid-term (more than 3 and less than 9 years)
- Long-term (more than 9 years)
These rates determine the minimum interest rate that must be charged on loans. If the interest rate charged is less than these amounts, then the tax laws require us to "impute" interest based upon difference between the required AFR and the actual interest rate charged in the note.
For example, assume the AFR for a five year loan is 5% and the loan charges no interest. If the balance on the loan for the current year if $100,000, then $5,000 of the payment would be considered interest and the remainder principal.
As most readers know, interest rates are nearing all time lows (at least for my lifetime) and the current AFR for short-term loans is .26%. That is correct 1/4 of one percent. On long-term loans, the required AFR is slightly more than 3.50%.
Therefore, any loans between family members should try to use these interest rates so you would not have to impute interest.
I expect to even see these rates go slightly lower next month and the month thereafter.