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An applicable federal rate (AFR) is an interest rate used by the Internal Revenue Service (IRS) for certain tax purposes. The IRS publishes tables of applicable federal rates for given time periods for the use of taxpayers and tax professionals, such as accountants. The most common use of the AFR is in calculating imputed interest to determine tax liability for interest on certain types of transactions.
Imputed interest is the interest assumed to be paid or received on a transaction, even if it has not occurred yet. The IRS views interest as taxable income, and if it is not declared on a transaction or the rate is low, it will use the applicable federal rate to determine how much tax to charge. In a simple example of how imputed interest can come into play, a person who holds a bond can be charged for the interest accruing on the bond before the interest is actually paid, and the applicable federal rate may be used to determine the appropriate tax liability.
For certain types of transactions, people may refer to the applicable federal rate when establishing a contract to write it with an interest rate that will be equal to imputed interest. If the contract doesn't specify the interest arrangements or if the interest rate is too low, the IRS will calculate imputed interest and charge taxes accordingly. Being aware of the applicable federal rate can allow people to avoid this problem.
The IRS gets its numbers from rates set by the United States Treasury. It publishes short-, mid-, and long-term applicable federal rates every month. When determining the federal applicable rate that should be used for a given transaction, the IRS looks at the rate for the given month and the two months previous. The assumption is that interest rates are unlikely to be lower than those set by the Treasury, so these rates are a good baseline for calculating imputed interest.
Paying taxes can get complex when deferred interest and other complex transactions are involved. Taxpayers may find it helpful to consult a tax attorney or accountant to get advice on filing taxes accurately. Although the IRS is forgiving about mistakes made in good faith, mistakes can tie up tax returns and other tax documents and create a great deal of work. Repeating mistakes can also arouse suspicion and expose a taxpayer to the risk of an audit, a procedure most people want to avoid even when their financial accounts are in impeccable order.