Why, How, and When
the IRS Sets
Applicable Federal Rates (AFRs)
Why, How, and When the IRS Sets Applicable Federal Rates (AFRs)
And Why AFRs Are Not the Federal Reserve’s Interest Rates
By Timothy Burke, National Family Mortgage ®
For informational purposes only; not tax or legal advice.
Executive Summary
Families and advisors working with intra-family loans frequently encounter confusion around Applicable Federal Rates (AFRs). A common question is whether AFRs are “set by the Fed,” how they relate to other well-known interest rates, and why the IRS publishes its own rates at all.
This article explains why AFRs exist, how they are determined, when they apply, and how they differ from monetary policy rates set by the Federal Reserve. Understanding this distinction helps families use AFRs appropriately–without assuming they function like market mortgage rates or policy benchmarks.
About This Topic
Intra-family mortgages involve tax rules, legal structure, and documentation details that are often more nuanced than traditional bank financing. This article explores those considerations in depth so families and advisors who want to understand why certain rules exist — and how they apply — have clear context.
In practice, National Family Mortgage simplifies these concepts into a clear, structured process for eligible families. How these principles are implemented — including loan documents, eligibility, and best practices — is defined by our Guides.
Why AFRs Exist
AFRs were created to address a specific tax concern: below-market lending between related parties.
Before Congress enacted the modern below-market loan rules, families and closely related parties could structure loans with little or no interest, effectively transferring value without triggering income or gift tax consequences. In response, Congress established statutory frameworks–most notably Internal Revenue Code §§ 1274 and 7872–to ensure that certain loans reflect an adequate rate of interest for tax purposes.
AFRs serve as a uniform federal benchmark for determining whether interest charged on a loan is sufficient under these rules. They are not designed to reflect market lending conditions or credit risk; instead, they function as a tax compliance reference point.
Who Sets AFRs
AFRs are published monthly by the Internal Revenue Service, but they are not created at the IRS’s discretion.
The rates are determined pursuant to statutory formulas enacted by Congress. The IRS’s role is administrative: it calculates and publishes AFRs in accordance with those formulas. The underlying data comes from U.S. Treasury obligations, not from the Federal Reserve’s policy rates.
This distinction matters. While the Federal Reserve influences short-term interest rates through monetary policy tools, AFRs are derived from historical Treasury market data, not from policy targets or forward-looking economic decisions.
How AFRs Are Calculated
Under IRC §1274(d), AFRs are based on the average market yield of outstanding, marketable obligations of the United States with comparable remaining maturities.
Key features of the calculation include:
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One-month averaging period
AFRs for a given month are based on Treasury yields observed during the one-month period ending before that month. -
Comparable maturity groupings
Treasury obligations are grouped by remaining maturity:-
Short-term AFR: loans with terms of 3 years or less (typically reflecting Treasury bills)
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Mid-term AFR: loans with terms longer than 3 years and up to 9 years (Treasury notes)
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Long-term AFR: loans with terms longer than 9 years (longer-dated Treasury notes and bonds)
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Smoothing, not spot rates
AFRs are not based on a single day’s yield or a policy announcement. They reflect averaged market yields over the prior month, which helps avoid volatility and provides a stable benchmark for tax analysis.
When AFRs Apply
AFRs are published monthly and generally apply based on the month in which a loan is executed or finalized.
For most intra-family loans and seller-financed transactions:
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The applicable AFR is determined by the loan’s stated term and the month of execution.
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Once a fixed-term loan is established, the AFR used at origination generally remains relevant for that loan, unless the loan is later refinanced or materially modified.
Because AFRs are backward-looking averages, they may appear out of sync with current mortgage rates or recent Federal Reserve announcements. That timing difference is intentional and reflects their purpose as a tax benchmark rather than a market pricing tool.
To see the current month’s published AFR table used in most family-loan planning, see AFR Rates.
Why AFRs Are Not the “Fed Rate”
AFRs are often confused with interest rates set or influenced by the Federal Reserve. While both relate to interest, they serve fundamentally different functions.
AFRs
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Published by the IRS under congressional mandate
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Derived from historical Treasury yields
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Used to evaluate tax treatment of loans
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Backward-looking and compliance-oriented
Federal Reserve Policy Rates
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Set by the Federal Open Market Committee
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Used to influence economic activity and inflation
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Forward-looking and policy-driven
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Not used as tax compliance benchmarks
In short, AFRs are tax rates, not monetary policy rates. They are designed to answer a narrow question–whether interest on a loan is adequate under federal tax law–not whether a loan reflects prevailing market credit conditions.
This distinction is also why bank-mortgage tactics like paying points to ‘buy down’ a rate don’t translate cleanly in family lending; see Why You Can’t “Buy Down” an Intra-Family Loan Rate — Even With Points.
AFRs in Other Areas of Federal Tax Law
While AFRs are commonly discussed in the context of family loans, they are not limited to intra-family transactions.
AFRs also appear in other areas of the tax code, including:
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Original issue discount (OID) calculations on certain debt instruments
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Installment sale rules involving deferred payments
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Employee compensation arrangements, such as below-market loans
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Valuation of certain deferred or contingent payment obligations
In each case, AFRs serve the same underlying function: providing a statutory interest benchmark for tax analysis. The mechanics and consequences can differ significantly depending on the context, which is why AFRs should always be applied with reference to the specific provision involved.
Why the Distinction Matters for Families
Understanding the origin and purpose of AFRs helps families avoid common misconceptions, including the assumption that AFR-based loans should mirror commercial mortgage pricing.
AFRs may be:
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lower than bank mortgage rates during periods of tight credit, or
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higher than expected during periods of rapidly changing market conditions.
Neither outcome indicates a flaw in the AFR system. It reflects the fact that AFRs are compliance benchmarks, not negotiated lending rates.
When families use AFRs appropriately, they are not attempting to “beat the market.” They are aligning private lending arrangements with federal tax expectations, reducing the risk of imputed interest or unintended gift characterization.
Frequently Asked Questions
Are AFRs set by the Federal Reserve?
No. AFRs are published by the IRS pursuant to federal tax statutes and are derived from historical Treasury yields. They are not policy rates set by the Federal Reserve.
Why do AFRs change every month?
AFRs are recalculated monthly because they are based on the prior month’s average Treasury yields. As market yields change, AFRs adjust accordingly.
Why can AFRs seem disconnected from mortgage rates?
Mortgage rates reflect credit risk, underwriting standards, and market conditions. AFRs reflect Treasury yields and serve as tax compliance benchmarks, not market pricing tools.
Do AFRs apply only to family loans?
No. AFRs apply in multiple areas of the tax code, including installment sales, original issue discount, and certain compensation-related loans.
Can a family choose any AFR it wants?
No. The applicable AFR depends on the loan’s term and the month in which the loan is executed.
Once a loan uses an AFR, does it ever change?
For a fixed-term loan, the AFR used at origination generally remains relevant unless the loan is refinanced or materially modified.
Conclusion
Applicable Federal Rates exist to support consistent tax treatment of loans, particularly between related parties. They are calculated under statutory rules, published monthly by the IRS, and derived from historical Treasury yields–not from Federal Reserve policy decisions.
Understanding why AFRs exist, how they are calculated, when they apply, and how they differ from monetary policy rates allows families and advisors to use them correctly and confidently. When viewed in their proper context, AFRs are neither arbitrary nor mysterious–they are a practical tool designed to bring clarity and consistency to private lending under federal tax law.
Technical Appendix: Statutory Context
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IRC §1274(d): Establishes the framework for determining AFRs based on Treasury yields
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IRC §7872: Governs below-market loans and potential imputed interest and gift consequences
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Treasury obligations: Provide the market yield data used in AFR calculations
Families and their advisors should consult applicable statutes, regulations, and professional guidance when applying these principles to specific transactions.
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.
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