Your grandson needs a car but cannot afford the payments. As a favor, you provide the $25,000 to purchase the vehicle. You tell your grandson to pay you back when he can, but there is no loan document. The IRS notices this payment during an audit and inquires about the source of your interest income for this loan. Should this happen, you will quickly understand the meaning of applicable federal rates, also known as AFRs.

What are applicable federal rates?

AFRs stand for Applicable Federal Rates. They are minimum interest rates that the IRS applies to a transaction when no rate is stated or implied. In other words, you may have a transaction that the IRS believes has an interest income/expense element to it, but you have claimed none. These minimum interest rates are published monthly by the IRS for three different loan terms:

1. Short-term (0 to 3 years)
2. Mid-term (4 to 9 years)
3. Long-term (over 9 years)

When does the AFR apply?

You may think that money you gave to a friend or that car sale to your cousin with repayment over time has no interest rate, but the IRS may see it differently. If no interest rate is stated, the IRS will apply the applicable AFR. This means you might be in for a tax surprise. Here are some common examples of when the AFR rates can come into play:

• Loans to family and friends
• Buying anything over time (if you take possession of an item and can pay for it over a length of time, imputed interest is involved)
• Employee advances, which can include granting an employee the rights of stock ownership, but not expecting immediate payment for the stock

How to use the AFR knowledge to your advantage

1. Create a loan document. Whenever you establish a transaction that requires repayment, draft a simple loan agreement. Not only will it clarify your repayment expectation, but it will also establish the repayment terms. Ensure both parties sign and date the document.
2. Establish a safe interest rate. Use the AFR tables to establish an audit-safe interest rate. Remember, AFRs are also used if the IRS believes your stated interest rate is too low.
3. Leverage gift rules. Remember, you (and your spouse) can each gift up to $19,000 to an individual in 2025. If you stay under this threshold, you can defend your money transfer as a non-interest-bearing gift rather than a loan.
4. Caution with housing transactions. Banks are asking buyers to document where they receive their money for their down payment. If the money comes from you, it could establish a potential implied loan document that you might need to defend. If you plan to help with a down payment in the future, try to understand the bank’s look-back rules for this disclosure reporting and use this knowledge in conjunction with the IRS gift rules to avoid creating implied interest.

Should you wish to see the published AFR rates, they are available on the IRS website at www.irs.gov/AFRs. As always, please don’t hesitate to contact our RRBB advisors if you have any questions.