Private Loans and Applicable Federal Rates
Are you interested in giving or receiving a private loan? This option may sound tempting, as private loans generally have better rates than standard bank loans. However, there may be unexpected tax consequences for both lenders and borrowers depending on the agreed-upon interest rate.
The Internal Revenue Service (IRS) provides a minimum interest rate, known as “applicable federal rates” (AFR), for private loans over $10,000. There are no penalties if the loan rate meets or exceeds the AFR. As a lender, you are able to claim the interest received as taxable income. As a borrower, you may be able to deduct the interest on your personal tax return (depending on what the loan was used for).
There are tax consequences should the loan rate fall below the corresponding AFR. As a lender, you could be subject to paying income taxes on the earned interest income of the AFR. If there is no interest rate, the IRS will view the loan as a gift and apply the borrower’s unpaid interest toward the lender’s annual $16,000 (as of 2022) per person tax-free gift limit. A borrower can also be taxed as if the loan was part of their income.
AFRs are adjusted every month by the IRS and will depend on the loan length term along with the time period over which the interest is compounded (whether annually, semiannually, quarterly, or monthly). There are three loan length terms with corresponding AFRs:
Short-Term Rates
Loans with a repayment term up to three years; rates are determined from the one-month average of market yields from marketable debt obligations (such as Treasury bills)
Mid-Term Rates
Loans with a repayment term between three and nine years; rates are calculated from bonds with maturities of more than three and up to nine years
Long-Term Rates
Loans with a repayment term greater than nine years; rates are determined from bonds with maturities of more than nine years
The IRS’s current AFRs can be found here: https://www.irs.gov/applicable-federal-rates.
It is always advisable you speak with your trusted tax professional to ensure you understand the structure of your private loan. It is also recommended that you properly document the terms of the agreement in order to avoid potential tax and legal disputes.
Did you know that SMART assists with loan document preparation for private loans? For additional information, contact Evelyn Miller, Partner, at 202-753-7400.
