IRS AFR Compliance for Intra-Family Loans and Seller-Financed Home Sales:

Understanding the Law, Common Myths, and Best Practices

By Timothy Burke, National Family Mortgage ®
For educational purposes only; not tax or legal advice.

Executive Summary

When families lend money or sell property within the family, federal tax law requires that the transaction be structured as a legitimate loan. To prevent private loans from being treated as disguised gifts, the Internal Revenue Code relies on a benchmark interest rate known as the Applicable Federal Rate (AFR).

Although some online sources suggest using “monthly” AFRs or the “lowest rate from prior months,” National Family Mortgage requires that all intra-family loans and seller-financed home sales meet or exceed the annual IRS Applicable Federal Rate in effect for the month of closing. This approach provides clarity, consistency, and strong protection against unintended tax consequences.

Intra-Family Loans and the IRS Applicable Federal Rate (AFR)

The Applicable Federal Rate (AFR) is published monthly by the IRS and reflects prevailing U.S. Treasury yields. It serves as the benchmark the IRS uses to determine whether a private loan charges sufficient interest to be treated as a bona fide loan rather than a gift.

If a family loan is written below the appropriate AFR, the IRS may treat part of the unpaid interest as a taxable gift and may also tax the lender as though interest had been collected even if it was not. Using at least the AFR helps ensure the loan is respected for tax purposes and avoids unnecessary gift-tax or imputed interest issues.

AFR Terms and Loan Length

The IRS publishes three AFR categories based on loan term:

Short-Term: Loans up to 3 years
Mid-Term: Loans longer than 3 years and up to 9 years
Long-Term: Loans longer than 9 years

To select the correct AFR, families must consider the repayment term of the loan and use the AFR for that term in effect for the month the loan is made. Once set, the AFR remains fixed for the life of a properly structured term loan. When interest rates decline after closing, families sometimes explore changes to an existing intra-family loan, which must be handled carefully to remain compliant.

All National Family Mortgage ® loans are term loans with a defined maturity date, providing predictability and long-term compliance.

Why the Annual AFR Is Used at Closing

Federal law defines the AFR on a semiannual-compounding basis. The IRS also publishes equivalent annual, quarterly, and monthly rates for reference.

Using the annual AFR in effect for the month of closing ensures that the loan meets or exceeds the statutory requirement, aligns with standard mortgage documentation, and provides a clear, consistent benchmark that avoids confusion or disputes. This standard is applied uniformly to all intra-family loans and seller-financed home sales.

Why Prior-Month or “Lowest-3-Month” AFRs Are Not Used

In limited circumstances involving installment sales, the tax code permits reference to AFRs from prior months. In practice, applying these rules to family transactions introduces unnecessary complexity and uncertainty.

Using the AFR in effect for the month of closing provides a straightforward, transparent standard that avoids misunderstandings about timing, reduces the risk of IRS scrutiny, and keeps documentation consistent and easy to understand.

Seller-Financed Family Home Sales

When a parent sells a home to a child and finances the purchase with a promissory note, additional tax rules may apply.

If the property is a primary residence, capital-gain exclusions may be available, but interest on the note remains taxable. If the property is a vacation home or rental, related-party rules may require that any gain be recognized immediately, even if payments are made over time.

Because these rules vary depending on property use and family circumstances, the same annual-AFR-at-closing standard is applied to all seller-financed transactions.

Bridge-to-Family Transactions

In some situations, parents purchase a home in their own name to help a child compete as a cash buyer and later transfer the home to the child using a family mortgage.

When this transfer occurs shortly after purchase and at or near the parents’ cost, there is typically no taxable gain, and the transaction is treated as a family financing arrangement. As with all family loans, the promissory note must include at least the annual AFR in effect for the month of closing and be properly documented.

Why Seller-Financing a Second Home Often Does Not Defer Taxes

When a rental or vacation property is sold within the family, federal law may prevent the use of the installment method to spread capital-gain taxes over time.

If the property is depreciable in the hands of the buyer, any gain is generally required to be reported in full in the year of sale, even if payments are made over many years. Seller financing can still serve family or cash-flow goals, but it does not always provide tax deferral for second homes or rental properties.

The Monthly Compounding Myth

A common misconception is that monthly payments require a “monthly-compounded” interest rate.

Standard mortgages–including those used by Fannie Mae, Freddie Mac, and National Family Mortgage–are simple-interest, annual-rate loans. Interest is calculated monthly using one-twelfth of the annual rate and is paid each month. Because the interest is never added to principal, no compounding occurs, even though payments are made monthly.

Monthly payments do not change the fact that the loan’s interest rate is annual.

Frequently Asked Questions

Do families have to charge interest on loans?
No, but if interest is charged below the AFR, the IRS may impute interest income and treat the difference as a taxable gift.

Can the monthly AFR be used if payments are monthly?
No. Monthly payments do not mean monthly compounding. Standard family mortgages use annual rates with simple interest.

Can AFRs from prior months be used?
While certain tax rules allow this in limited circumstances, using the AFR in effect for the month of closing provides clarity and consistency.

What happens if a loan is written below the AFR?
The lender may be taxed on imputed interest and may reduce their available annual gift-tax exclusion.

Conclusion

Using the proper Applicable Federal Rate is one of the most important steps in creating a compliant intra-family loan or seller-financed home sale. Applying the annual IRS AFR in effect for the month of closing helps families avoid unintended tax consequences, maintain clear documentation, and structure transactions that are respected under federal tax law.

Technical Appendix: Why the Annual AFR Is Used

1. Statutory Foundation

IRC §7872(f)(2) defines the Applicable Federal Rate by reference to IRC §1274(d), which specifies semiannual compounding. This statutory definition governs all below-market and intra-family loans.

2. Proposed Regulations

Proposed Treasury Regulation §1.7872-3(b)(1) suggested that AFR compounding could match payment frequency (monthly, quarterly, etc.). These regulations were never finalized and therefore carry no binding legal authority.

The IRS publishes equivalent compounding rates for computational convenience only.

3. Judicial Treatment of Proposed Regulations

The U.S. Tax Court has consistently held that proposed regulations are advisory, not controlling:

KTA-Tator, Inc. v. Commissioner, 108 T.C. 100 (1997)
Estate of Howard v. Commissioner, T.C. Memo 2012-21
Elkins v. Commissioner, 81 T.C. 669 (1983)

When proposed regulations conflict with statutory language, the statute controls.

4. Compounding vs. Payment Frequency

Interest compounding and payment frequency are separate concepts. In standard mortgage lending, interest is calculated monthly but paid as simple interest. Because each month’s accrued interest is paid in full, it never becomes part of the loan balance and does not compound.

This structure satisfies the statutory AFR requirement without converting the loan into a “monthly-compounded” obligation.

5. Installment Sale Considerations

Although IRC §1274(d)(2) allows limited look-back rules for certain installment sales, related-party provisions (§§453(e) and 453(g)) can accelerate or disallow installment treatment, particularly for depreciable property.

Applying a uniform AFR standard avoids misapplication of these rules.

6. Conclusion

Using the annual AFR in effect for the month of closing exceeds the statutory minimum, aligns with standard mortgage practice, and provides a conservative, defensible approach for all intra-family loans and seller-financed home sales.

About the Author

Timothy Burke is the founder of National Family Mortgage ®, an online company focused on helping families document and support compliant intra-family mortgage loans and seller-financed home transactions. His work focuses on proper documentation, alignment with applicable federal tax rules, and practical implementation considerations for families and their professional advisors navigating private family financing.

Families and their advisors should consult applicable statutes, regulations, case law, and professional guidance when applying these principles to specific transactions.