What Are Minimum-Interest Rules?
Minimum-interest rules refer to a federal law that requires that a minimum rate of interest be charged on any loan transaction between two parties. The minimum-interest rules mandate that even if the lender charges no rate, an arbitrary rate will be automatically imposed upon the loan.
The minimum-interest rules are at least partly intended to prevent excess gifting between taxpayers via intra-family loans with no or below-market interest rates. For this reason, minimum-interest rules apply regardless of the relationship between the borrower and lender, even if they are related.
Key Takeaways
- Minimum-interest rules refer to government regulations that require a minimum federal interest rate on lent money.
- Published monthly by the IRS, the Applicable Federal Rate (AFR)—sometimes known as the "arm's length" rate—dictates these minimum-interest rules.
- The IRS created the minimum-interest rules to prevent you from making large interest-free loans to family members or close associates.
Breaking Down Minimum-Interest Rules
Minimum-interest rules are fairly complex and have been subject to numerous changes and modifications. There are separate rules for personal and commercial loans and sales of property that are financed by the seller.
Lenders can face tax penalties from the IRS if they don’t adhere to the minimum interest rules, even if the borrower is a close family member. For example, lenders can be charged tax on the amount of interest the IRS believes they should have collected on a loan, even if they didn’t collect any interest themselves. The amount of any unpaid interest on a loan could also be counted toward a taxpayer’s annual gift limit, leading to double taxation on the money.
Lenders could be required to report with their taxes any interest they received in excess of the principal loan amount.
Note
Minimum-interest rules require that some rate of interest be charged on any loan transaction between two parties.
Potential Exceptions to Minimum-Interest Rules
According to Section 7872 of the Internal Revenue Code, there are some exceptions to the rules for direct gift loans between individuals if the amount is below $10,000. However, this exception doesn't apply to gift loans made for the acquisition of income-producing assets.
Gift loans up to $100,000 might also qualify as an exception to the rules under particular circ*mstances. The loan must be granted to a relative or child to buy a home or launch a business. Furthermore, the borrower’s net investment income must be $1,000 or less for the year.
If the total outstanding balance in gift loans exceeds the limits during the year, then the loan will be subject to interest rules. If the net investment income of the borrower exceeds the $1,000 threshold, imputed interest rules would apply but only on their net investment income.
There are other instances where the providing of funds could be classified as a loan that may fall within interest rules. For example, funds granted to senior continuing care facilities as part of the fees paid for ongoing care may qualify as a loan if it exceeds certain limits and is considered refundable.
Note
Imputed interest can be avoided on other loans as long as the current federal interest rate is applied to them. The rates are set monthly by the IRS via the AFR.
For term loans, the rate that should be applied is the federal rate that was set on the day the loan was made. For loans that have a term that is less than three years, the short-term rate would apply. Mid-term rates would apply on loans with terms of three to nine years. Loans with greater than a nine-year term, the long-term rate would apply.
What Is the Minimum Interest You Can Charge on a Loan?
There is no minimum interest rate you are required to charge, but you will be liable for taxes to the IRS if you decide to give a below-market-interest loan to someone, including a family member. This is because as a lender, you are expected to charge market interest and if you don't do so, you are in effect liable for the interest foregone on the loan.
Why Were the Minimum-Interest Rules Created?
The IRS devised the minimum-interest rules to prevent taxpayers from making large interest-free loans to family members or close associates.
As an Example, What Is the AFR for August 2023?
Applicable Federal Rates (AFRs) tend to be significantly lower than the market rates charged by banks. There are many AFRs for various terms of loans with differing interest-compounding structures. While regularly adjusted, as an example, the main AFRs for September 2023 for short-term loans were: 5.12% for an annual compounding period, 5.06% for a semiannual compounding period,5.03% for a quarterly compounding period, and 5.01% for a monthly period. These lowest-allowable rates are published on a monthly basis by the IRS and several other publications.
The Bottom Line
The IRS doesn’t want you making interest-free loans of substantial amounts to your family. Because of this, you will face taxes if you don't comply with the minimum-interest rules.
If you choose not to charge a family member interest that is at least equal to the AFR, the IRS may tax you on the difference between the AFR and the interest rate actually charged. If the borrower uses the money to generate income (like investments or making a profit), you will need to report the interest income onyourtaxes, too.
