Minimum Interest Rate to Charge on Personal Loans – IRS Rules

You may be aware that there is a maximum interest rate that can be charged when lending money to someone personally. If you charge an interest rate that is too high, it is considered usury and you would be classified as a loan shark. Loan sharks face imprisonment, which is something you definitely want to avoid! Usury refers to the practice of charging an excessively high interest rate that is considered unreasonable. Each state has its own laws and criteria for determining what is considered unreasonable. Currently, in California, the general usury limit is 10% per year, with certain exceptions.

Minimum Interest Rates?

However, it’s important to note that there is a legal requirement for a minimum interest rate when lending money to someone. Occasionally, I receive calls from parents who want to assist their children in purchasing a home. The conversation typically goes like this: “Hey Mark, we are aware that you and Viv are the top realtors in San Carlos, and possibly even the world, and we need your assistance. Junior needs a home in San Carlos, and we want to support him. However, the current interest rates are quite high. Therefore, we were thinking of purchasing the house with cash and having Junior repay us on a monthly basis at a lower interest rate.”

At times, I find myself having to explain the concept of the Applicable Federal Rate (AFR) to my parents. AFR refers to the minimum interest rate set by the Internal Revenue Service (IRS) for private loans. The IRS releases a set of minimum interest rates every month, known as Rate Tables, which are considered the minimum market rate for loans. It is important to select the appropriate AFR based on whether the loan is short-term or long-term.

If the interest rate on a loan is lower than the Applicable Federal Rate (AFR), it could have tax consequences. Such rates are typically lower than the rate on a 30-year fixed mortgage. When lending money to a family member or friend, it is important to charge at least the AFR or slightly more, but not too high as to be considered a predatory lender.

If you break the AFR rules regarding minimum interest rates, there can be several consequences. Firstly, the income earned will be subject to imputed interest, which means that taxes will be paid based on the AFR rather than the actual amount charged. Secondly, if the loan amount exceeds the annual gift tax exclusion, it may result in a taxable event, leading to income taxes being owed. The IRS may also impose penalties depending on the situation.

The Work Around

If you desire to charge interest rates higher than what is permissible for a personal loan without facing legal charges, you can establish an LLC and have it issue the loan instead. This way, the loan will not be considered a personal loan and will not be subject to usury laws. This approach may also be applicable when the minimum interest rate you intend to charge is lower than the AFR. However, it is advisable to consult with a lawyer or accountant to ensure the legality of this workaround as laws are subject to change.

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