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Definition: Applicable Federal Rate (AFR)
Applicable federal rates (AFRs) are monthly rates that are published by the Internal Revenue Service (IRS) to calculate the imputed interest for income tax purposes. Imputed interest is the interest that is considered as an expense for tax purposes even though no actual interest payment has been made. AFRs specify the minimum interest rate for a loan that must be charged so as to be considered as a market-rate loan.
Individuals and corporations sometime issue loans at no or very low interest rates that are below the normal market rates. Suppose that an individual grants a 1- year loan of $1000 to another for a rate of interest of 1%. Assume that the AFR that has been prescribed by the IRS is 5%. You would earn an interest of $10 while you would have earned $50 had you charged an interest rate equal to the AFR. This difference between the actual interest earned and the interest earned at AFR is called imputed interest or forgone interest, since it is the amount that is not collected as a result of lending at rates lower than the market rate. The lender must report this imputed interest along with the actual interest earned for tax purposes.
AFRs are published monthly by the IRS in accordance with section 1274(d) of the Internal Revenue Code and they are based on the average market yields of marketable obligations that are outstanding such as the US Treasury bills. AFRs are classified as short term (for instruments with terms of 3 years or less), medium term (for instruments with terms between 3 and 9 years) and long term (instruments with terms greater than 9 years). There are some exceptions to the AFR rules. One such exception is that loans between individuals of $10,000 or less are not subject to the tax reporting rules as determined by IRS.
The AFRs published by the IRS for the month of December 2014 are given below: