Dear Dr. Don,
I understand that one must pay the applicable federal rates in a family loan situation in order for the loan to not be counted as a gift. My closing is tentatively scheduled for Sept. 1. When will the Applicable Federal Rates, or AFRs, for September be published?
— Susan September
The applicable federal rates are published in several places, but I’ve found the easiest to use to be the “Index of Applicable Federal Rates (AFR) Rulings” available on the Internal Revenue Service Web site. The IRS releases a revenue ruling on the AFRs each month
Your tax professional will have to provide the final word on this, but you should be able to use the applicable rates posted in either July or August as the AFR for the loan. For a term loan, this rate would apply for the life of the loan. The applicable federal rate is determined by the length of the loan. Short-term loans have a final maturity of three years or less. Midterm loans are more than three years but less than nine years. Long-term loans have a final maturity of more than nine years.
It is possible to finesse the loan term issue by making the loan a demand loan, meaning the lender can call the loan on demand, versus a term loan. Talk to your tax adviser to determine if that’s in your best interest.
While you’re right about needing to pay at least the AFR to make sure you do not receive a gift of interest, the lender can choose to make a gift in the form of an interest subsidy up to the annual exclusion limits with no gift tax implications. The annual exclusion limit is $13,000 for 2009 and with spouses that use gift splitting the annual exclusion goes to $26,000. The other tax implication of the loan is one of federal income taxes due on the imputed interest payments.
There are important exceptions to the below-market interest rules. IRS publication 550, “Investment Income and Expenses,” has a whole section on below-market loans.
You didn’t say whether you’re the borrower or the lender, but I hope all of this information has convinced you to work with your tax professional to structure the note so that the tax implications are understood, and managed, by both parties to the note. This isn’t a do-it-yourself project, and I can’t offer you tax or legal advice on the matter.
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