The Internal Revenue Service has published the January 2022 Applicable Federal Rates (AFRs). The minimum interest rates that should be charged for family loans to avoid tax complications are represented by AFRs, which are published on a monthly basis.
The Section 7520 interest rate for January 2022 is 1. 6 percent. A “grantor retained annuity trust,” or “GRAT,” is a popular estate tax planning strategy that uses the Section 7520 interest rate. “Generally speaking, the transaction is more effective at lowering estate taxes the lower the interest rate.”
Please get in touch with a member of our Trusts & Estates group for more details about potentially taking advantage of these low AFRs.
How Does the Applicable Federal Rate Work?
The Internal Revenue Code’s Section 1274(d) provided for the applicable federal rate, which is the interest rate permitted for private loans. Private lenders are not allowed to charge below the AFR but are allowed to charge above it. The IRS can compare the interest rates charged on loans by various market participants using the AFR. Additionally, when family members or other connected parties are involved in a loan transaction, they are not allowed to set interest rates below the AFR. For instance, if you lend money to your sister or mother, you must charge them an interest rate that is slightly higher than the AFR but not below it.
Three Distinct Rates
The IRS releases three different types of applicable federal rates (AFR) each month: short-term, mid-term, and long-term AFR rates. Loans with a maturity of three years or less are subject to the mid-term AFR rate, while loans with a maturity of three to nine years are subject to the short-term AFR rate. For loans with maturities of more than nine years, the long-term AFR rates apply.
Following are some crucial details regarding the applicable federal rate (AFR):
The tax consequences of lenders charging less than the AFR rate are felt by both parties.
Example of How to Use the Applicable Federal Rate (AFR)
The Internal Revenue Service published a federal rate of 2 in 2019. 72%, 2. 89%, and 3. 15% as short-term, mid-term and long-term AFR rates respectively. The mid-term AFR rate will be applied if a party lends a family member, for example, $50,000 over four years. Whenever a loan is taken out for a term of three years or less, 72% or more will be charged as the interest rate. Both parties may be subject to tax consequences if an interest rate that is lower than the AFR rate is charged. Based on particular factors, the IRS modifies the AFR rate.
Practical Uses of AFR
The IRS monitors market compliance with the published interest rates using the applicable federal rates. In order to determine the appropriate AFR rate, parties to a loan agreement must take into account the loan’s term and maturity. The original issue discount, unstated interest, and income tax consequences that will be applied to interest rates below the AFR rates are also determined by the IRS using the AFR rates. In actual circumstances, the parties to a loan agreement must abide by the AFR made available by the IRS. If a lender sets interest rates below the published AFR, the IRS and the degree of AFR defiance may impose tax consequences or other penalties.
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FAQ
What AFR rate should I use?
The AFR limits how lenient a private loan’s terms can be. The IRS published an annual short-term AFR of 1. 85%, mid-term AFR of 2. 51%, and long-term AFR of 2. 66% in April 2022.
What is the 110 AFR rate used for?
An asset is sold and then leased back for use in a leaseback or sale-leaseback transaction. The standard for such transactions is that 110% of the applicable federal rate must be used. Additionally, there are situations in which the AFR is not applicable.
What is the 120% AFR rate used for?
To be used to value certain charitable interests in trusts. In accordance with Internal Revenue Code 7520, the interest rate is equal to 120 percent of the applicable federal midterm rate (compound annually) for the month in which the valuation date falls.
Which AFR is used for demand loans?
A demand loan qualifies as a short-term obligation under the short-term AFR because it can be called as due at any time by the lender.