Applicable Federal Rate (AFR)

The applicable federal rate is defined at IRC 1274(d) as the interest rate that applies, for a given debt instrument, according to its term. Section 1274(d)(1)(A) sets out the table: for a debt instrument with a term "not over 3 years," the applicable federal rate is the federal short-term rate; "over 3 years but not over 9 years," the federal mid-term rate; "over 9 years," the federal long-term rate. Section 1274(d)(1)(C)(i) derives the short-term rate from "the average market yield ... on outstanding marketable obligations of the United States with remaining periods to maturity of 3 years or less," and the mid-term and long-term rates are determined on the same principles for their maturities.

The AFR exists because a below-market interest rate is a way of transferring value without calling it a transfer. Rather than police that case by case, the Code sets a floor and treats the shortfall as whatever it economically is: a gift, compensation, a dividend, or unstated interest on a sale. The rate is a reference point, not a rule of its own, and the consequences of charging less live in the sections that borrow it.

It is worth separating from the rate it is most often confused with. The federal funds rate is the Federal Reserve's monetary policy target for overnight interbank lending. The applicable federal rate is an IRS figure derived from Treasury yields and used to test interest adequacy for tax purposes. Neither is set by reference to the other, and a change in one does not mechanically move the other.

The one-month lag, and why it is useful rather than an inconvenience. Section 1274(d)(1)(B) provides that "during each calendar month, the Secretary shall determine the Federal short-term rate, mid-term rate, and long-term rate which shall apply during the following calendar month." So the rate a transaction uses is published before the month in which it applies, and anyone papering a note has the number in hand ahead of the date they need it.

The lowest 3-month rule, which is the AFR's only genuine planning feature. For a sale or exchange, section 1274(d)(2) substitutes "the lowest 3-month rate," defined as "the lowest of the applicable federal rates in effect for any month in the 3-calendar-month period ending with the 1st calendar month in which there is a binding contract in writing for such sale or exchange." In a period of rising rates that lets an installment sale reach back up to two months for a better number. Note the scope precisely: the rule is written for a sale or exchange, and it is not a general permission to shop three months of rates for any loan.

Term is measured with options in it. Section 1274(d)(3) provides that in determining a debt instrument's term, "there shall be taken into account options to renew or extend." A five-year note with two five-year renewal options is not automatically a mid-term instrument, and getting the band wrong is the commonest way to use the wrong AFR while believing you used the right one. The boundaries themselves are also easy to state loosely: three years exactly is short-term because the band is "not over 3 years," and nine years exactly is mid-term because that band runs to "not over 9 years."

What is actually published each month. The IRS issues the rates as a revenue ruling, and the same ruling carries several related figures. Table 1 gives the short-term, mid-term and long-term AFRs for purposes of section 1274(d), each at annual, semiannual, quarterly and monthly compounding, together with the 110, 120 and 130 percent multiples of each and the 150 and 175 percent multiples of the mid-term rate. Table 2 gives the adjusted AFRs for purposes of section 1288(b), used for tax-exempt obligations. Table 3 gives the adjusted federal long-term rate and the long-term tax-exempt rate described in section 382(f), which limits the use of a corporation's losses after an ownership change. Table 4 gives the low-income housing credit percentages under section 42(b)(1). Table 5 gives the section 7520 rate, which section 7520(a)(2) sets at "120 percent of the Federal midterm rate in effect under section 1274(d)(1) for the month in which the valuation date falls," rounded to the nearest two tenths of one percent, and which is used to value an annuity, a life interest, a term of years, a remainder or a reversion. Choosing the wrong table is a real error: a charitable remainder trust is valued with the section 7520 rate, not with the plain AFR.

One 110 percent case sits in section 1274 itself. Subsection (e) provides that where a debt instrument is given for property that the transferor or a related person then leases back, the discount rate is 110 percent of the applicable federal rate, compounded semiannually. That is a separate rule from the multiples published for other sections' use.

Where the AFR is consumed. Section 7872 uses it to impute interest on below-market loans, which is the rule that makes a family loan at zero interest a partial gift; the family-loan mechanics, the de minimis exceptions and the gift consequences belong to the intrafamily loan page. Sections 483 and 1274 use it to recharacterize part of the deferred payments on an installment sale as unstated interest, which is the seller-financing case. Section 7520 uses 120 percent of the mid-term rate to value split-interest transfers. Section 1288 uses an adjusted AFR for tax-exempt obligations. The revenue ruling that publishes the rates lists the sections it serves on its face, which is a quicker way to check whether a given provision uses this rate than reading the provision.

Each month the IRS determines the short-term, mid-term and long-term rates from average market yields on Treasury obligations of the corresponding maturities, and publishes them in a revenue ruling for use in the following month. A person papering a transaction identifies the term of the debt, taking renewal and extension options into account, and reads the rate for that band from the ruling covering the month the transaction occurs. Where the transaction is a sale or exchange, they may instead use the lowest applicable federal rate in effect in the three calendar months ending with the first month there is a binding written contract. They then select the compounding period the instrument actually uses, because the ruling prints a different figure for annual, semiannual, quarterly and monthly compounding.

A hypothetical example of picking the right band and the right table. Suppose a note runs for eight years with a single option to extend it by three more. Read on its stated term alone, eight years falls in the "over 3 years but not over 9 years" band and takes the mid-term rate. But section 1274(d)(3) requires renewal and extension options to be taken into account, so the term to test is eleven years, which is "over 9 years" and takes the long-term rate. Now suppose the same parties are instead valuing a ten-year annuity interest for gift tax purposes. Neither the mid-term nor the long-term AFR is the right number: section 7520 requires 120 percent of the federal mid-term rate for the month of the valuation date, rounded to the nearest two tenths of one percent, which the IRS publishes as its own table in the same ruling. No rates are given here because they change every month; the point of the example is that the term, the options and the Code section between them decide which published figure applies.

Why the AFR is useful

• It gives a bright line. A loan at or above the applicable federal rate for its term is not a below-market loan, which removes the imputed-interest question entirely.
• It is published in advance of the month it applies to, so the number is available before the documents are signed.
• It is generally well below commercial rates, so an intrafamily or seller-financed arrangement can be genuinely cheap for the borrower and still be respected.
• The lowest 3-month rule gives a real, statutory look-back for a sale or exchange.

Where it trips people up

• It changes every month, so any figure quoted in an article, a template or a spreadsheet is stale almost immediately.
• The term bands are boundary rules, and renewal or extension options count toward the term, so a note can sit in a different band than its stated maturity suggests.
• The published ruling contains several different rates, and the AFR is not the right one for every purpose. Valuing an annuity or a remainder takes the section 7520 rate; a tax-exempt obligation takes the adjusted AFR.
• Each rate is printed at four compounding periods, and using the annual figure for a monthly-compounding note is a small but real error.
• It is routinely confused with the federal funds rate, which is a monetary policy target and has nothing to do with imputed interest.