Do you keep up with fluctuations in interest rates? The IRS does too, and changes in those rates could affect your tax return. For instance, applicable federal rates, or AFRs, are published by the IRS to set a minimum interest rate for certain transactions, such as loans to family members.
How Interest Rates Affect Your Taxes
Loans you make that carry an interest rate lower than the market offers can be considered a taxable transfer for income and gift taxes. The result: You might have taxable income even if you receive no interest, and a gift tax return may be required. Not reporting the income or not filing a gift tax return when necessary could lead to penalties.
Establishing a written loan agreement with a stated interest rate – for example, the AFR in effect for the month of the loan – helps avoid misunderstandings.
The IRS also publishes interest rates that apply to the underpayment and overpayment of taxes. Say you get a notice increasing the liability on your federal return – in other words, you’ve underpaid your taxes. You’ll generally owe interest at the applicable rate from the due date of the return until you make payment. The interest is compounded daily and applies to penalties as well as to the underpaid tax.