Low Interest Rates Make Intra-family Loans Appealing
By Kristi Mathisen and Barbara Potter
The Applicable Federal Rate
The key to transferring wealth through intra-family loans is the applicable federal rate, or AFR. The AFR is the rate at which the loan will be evaluated for both income and gift tax purposes. If a note requires a child to pay a parent no interest or an interest rate that is less than the appropriate applicable federal rate, the transaction will be characterized, at least in part, as a gift from the parent to the child and the income tax effects described above will occur. The caveat is also true. If the stated interest rate is at least the AFR, there is no gift element in the transaction, unless the interest is not in fact paid.
AFRs are determined by the IRS each month.3 The rates vary depending on the term: short-term for obligations due in less than three years, long-term for those due in more than nine years, and mid-term for everything in between.4 Applicable federal rates are by no means market rates. They are based on the rates for various treasury securities during the previous month. These rates are almost always less than commercial or retail rates and therein lies their great appeal with today's low treasury rates.
Adjustable Federal Rates (IRS)
http://www.irs.gov/app/picklist/list/federalRates.html
Other IRS references
http://www.irs.gov/publications/p550/ch01.html
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