First in the series: A is for Applicable Federal Rates, or AFRs.
Each month, the IRS provides various prescribed rates for federal income tax purposes; those rates are regularly published as revenue rulings. You can see the latest list of rates as a revenue ruling here (downloads as a pdf).
If you browse the list, you’ll note a few different versions of the AFR:
- Current Short Term AFRs for terms of three (3) years or less;
- Current Mid Term AFRs for terms in excess of three (3) years but no greater than nine (9) years;
- Current Long Term AFRs for terms in excess of nine (9) years;
- Current Adjusted Long Term Rates for determining the Long Term Tax-Exempt Rate, used to compute the annual net operating loss carryover utilization limitation following a change in ownership; and
- Current Section 7520 Rate, used to value annuities, life interests or interests for terms of years and remainder or reversionary interests.
So, what in the world does all of this mean?
The easiest way to think of AFRs is that they’re guidelines that the IRS uses to determine interest rates for certain transactions. Commonly, these numbers are used to determine imputed interest (for family loans, for example).
Planners and other tax professionals watch these rates fairly closely because they can present some interesting opportunities. This is especially true when dealing with deferred or split interest gifts; examples of those include a charitable trust when part of the gift is going to a charity and part of the gift is going to a non-charitable beneficiary. Under the statute, the person making the gift can choose the most favorable AFR (that section 7520 rate alluded to above) over a period of about three months. That can be helpful because with something like a charitable remainder trust, you’d want to choose a high number, and for charitable lead trusts and remainder interests, you’d generally want to choose a low number.
The AFR is also used to calculate withdrawal amounts from IRAs. The IRS requires the use of AFRs for purposes of amortization calculation (stay with me) for figuring certain IRA withdrawals since the interest rate must be “reasonable” (and that’s based on the AFR). You might not actually plug those numbers in yourself but someone does when figuring how much your IRA withdrawals (using the amortization and annuity factor methods).
If your eyes glaze over while looking at the tables, you’re not alone. While many tax pros swear by the tables (my former law professor still calculates split interest gifts by hand using the tables), others opt to skip the tables altogether and go straight for the software. There is software available now that does all of these split interest, imputed interest and other calculations that rely on the AFR.
Chances are that you won’t ever have to use an AFR to make a calculation yourself (unless you’re a tax pro). But now you know what it is which is good to know if you have to deal with loans, IRAs or gifts. If nothing else, it makes good cocktail party chatter…
