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What About Those AFRs?

Published on: 23:26PM Sep 21, 2015

Periodically I will get a question from a client asking me "How much interest they have to charge on a loan to their child or some other related party?".  The answer can be a little b confusing.  You are not required to charge interest on any loan; however, we recommend that you at least charge the "Applicable Federal Rate" (AFR) on any loan that you make.  If you do not charge at least this amount, then you may become subject to some unpleasant income/gift tax costs.

The IRS issues a table each month showing the AFRs.  These rates are listed for short-term (less than 3 years), mid-term (between 3 and 9 years) and long-term (greater than 9 years).  These rates are then listed by compounding periods (annual, semiannual, quarterly and monthly) and by various percentages of the AFR (certain gift and/or income tax rules require a rate higher than the AFR which can be as high as 175% of the mid-term AFR).  There are also additional rates listed for very specific parts of the Internal Revenue Code.

The October, 2015 short-term rate is .55% (annual), mid-term is 1.67% and long-term is 2.58%.  Let's go through an example as to how this may work if no interest is included in the transaction:

Assume Dad would like to sell land to his daughter for $250,000 with no money down and 10 annual payments of $25,000 at the end of each year.  There is no interest in this note, however, for income tax purposes, we are required to impute interest using the applicable rate.  In this case, the rate is 2.58% (greater than 9 years).  We plug all of these variables into a loan amortization program and based on 10 years of $25,000 payments at 2.58%, we come up with a loan value of $217,900 (rounded).  This is the price that dad and daughter will use for their sales price and cost basis.  When daughter makes the first payment, it will be composed of $19,378.18 of principal and $5,621.82 of interest.  Dad will be required to report this amount of interest and daughter will be allowed to deduct this amount as interest expense.  Each year, the interest will go down a bit and principal will go up by the same amount.

Now that example was not too bad for daughter since she got to deduct some interest.  Dad may not be too happy since he has to pay ordinary tax rates on interest and has less capital gains.  Now, let's assume dad sells a personal asset to daughter for the same terms.  In this case, dad reports income the same, however, daughter now has non-deductible interest expense (neither one is happy now).

In the case of making a loan directly to/from a related party, a gift may occur and/or non-deductible interest may result.  This is usually the taxpayer's worst case.  The calculation of the required interest is fairly easy to do.

Just remember, you are not required to charge interest on a loan, but if you don't; you still will be required to report interest in most situations.