What is the difference between the AFR rate and the adjusted AFR rate?

Introduction

The primary difference between the Applicable Federal Rate (AFR) and the Adjusted AFR lies in the tax status of the underlying obligation.

• AFR is the baseline interest rate for taxable transactions. It reflects the borrowing cost of the U.S. government (risk-free rate) and serves as the minimum interest rate the IRS requires for private loans to avoid "imputed interest" or gift tax consequences.
• Adjusted AFR is the rate used for tax-exempt obligations (such as municipal bonds). Because the interest on these instruments is not subject to federal tax, the rate is mathematically lowered to be comparable to a taxable rate on an after-tax basis.

These rates are published monthly by the IRS in the Internal Revenue Bulletin (IRB) in the same Revenue Ruling.

Core Explanation

1. Applicable Federal Rate (AFR)

Defined under IRC § 1274(d), the AFR is determined based on the average market yield of outstanding marketable obligations of the United States.

• When it applies: It is used for standard private lending, family loans, and seller-financed sales of property where the interest is taxable to the lender.
• Categories:
  • Short-term: Loan term of 3 years or less.
  • Mid-term: Loan term over 3 years but not over 9 years.
  • Long-term: Loan term over 9 years.
• Key Uses:
  • IRC § 7872: Determining if a loan is "below-market" for gift tax purposes.
  • IRC § 1274: Calculating Original Issue Discount (OID) on debt instruments issued for property.
  • IRC § 483: Imputing interest on certain deferred payments.

2. Adjusted AFR

Defined under IRC § 1288(b), the Adjusted AFR is the AFR reduced to take into account the tax exemption for interest on the obligation.

• When it applies: It is strictly for calculations involving tax-exempt bonds or specific tax credits where the underlying calculation must reflect a tax-free yield curve.
• Calculation: The IRS calculates this by adjusting the standard AFR by a factor that represents the yield relationship between tax-exempt municipal bonds and taxable Treasury bonds. As a result, the Adjusted AFR is always lower than the standard AFR.
• Key Uses:
  • IRC § 1288: Determining OID accruals on tax-exempt obligations.
  • IRC § 382: Calculating the "Federal long-term tax-exempt rate," which limits the use of Net Operating Losses (NOLs) after a change in ownership. (Note: The § 382 rate is specifically the highest Adjusted Federal Long-Term Rate over the current and prior two months).
  • IRC § 42: Calculating the applicable percentage for the Low-Income Housing Tax Credit (LIHTC).

Legislative Update Note (2026)

While the One Big Beautiful Bill Act (effective July 2025) introduced changes to various agricultural loan rates and extension of tax brackets, it maintained the fundamental definitions and calculation methods for § 1274 AFR and § 1288 Adjusted AFR as described above.

Audit and Practitioner Considerations

The IRS frequently scrutinizes the selection of the interest rate in related-party transactions and corporate restructurings.

1. Rate Mismatch Risk: Using the Adjusted AFR for a standard family loan or intercompany loan is a critical error. Because the Adjusted AFR is lower, using it for a taxable loan results in insufficient interest being charged under § 7872, potentially triggering gift tax (for individuals) or constructive dividends (for corporations).
2. Section 382 Limitation Calculation: When calculating the annual limitation on NOLs after an ownership change, practitioners must use the Federal long-term tax-exempt rate, which is derived from the Adjusted Long-Term AFR. Using the standard Long-Term AFR would result in an incorrect (and likely overstated) limitation amount.
3. Documentation: The loan agreement must explicitly state the interest rate. If the rate floats, the document should reference the specific AFR index (e.g., "Short-term AFR in effect for the month of compounding").
4. Timing: Ensure the rate selected corresponds to the correct month. For sales of property, the "lowest of the past 3 months" rule under § 1274(d)(2) often allows taxpayers to lock in a lower standard AFR, but this rule does not apply to all Adjusted AFR uses.

Summary

• AFR (§ 1274):
  • Basis: Taxable Treasury yields.
  • Use: General private lending, family loans, taxable OID.
  • Rate Level: Higher (Standard market rate).
• Adjusted AFR (§ 1288):
  • Basis: Tax-exempt municipal yields.
  • Use: Tax-exempt bonds, § 382 NOL limitations, LIHTC.
  • Rate Level: Lower (Tax-discounted rate).

Suggested Next Steps

• Consult the Monthly Revenue Ruling: Locate the current month's Revenue Ruling (e.g., Rev. Rul. 2026-XX) to see the specific rates side-by-side. Table 1 typically lists standard AFRs, while subsequent tables list Adjusted AFRs.
• Review Loan Documents: If drafting a promissory note for a client, confirm the transaction is fully taxable before selecting the standard AFR.
• Check § 382 Calculations: If handling a corporate acquisition involving loss carryforwards, ensure the "Long-Term Tax-Exempt Rate" (derived from Adjusted AFR) was used for the limitation calculation.