What to Know About IRS Interest Rates

There’s a great deal of interest these days in interest rates. The Federal Reserve raised its rate, called the “Fed funds rate,” on May 5, 2022, to 0.75% to 1.00% (it can fluctuate slightly within those parameters day to day) and indicated that there are more increases to come before the end of 2022. The IRS has various interest rates for different tax purposes and they, too, are on the rise. Here’s what you need to know about the different IRS interest rates.

IRS interest rates on overpayments and underpayments

Each quarter, the IRS fixes an interest rate that it charges on underpayments or pays to taxpayers on overpayments (refunds). It usually announces any changes by the last week of the prior quarter. For example, the rates for individuals for the third quarter of 2022 are 5% for overpayments and underpayments, or one percentage point higher than in the second quarter of 2022. If, for example, you failed to pay all of your 2021 federal income taxes due on April 18, 2022, the interest charged on the outstanding balance during the third quarter of 2022 is 5%, computed on a daily basis.

Note: The IRS does not pay interest on a tax refund (an overpayment) unless is it later than 45 days. Interest received on an overpayment is includible in gross income.

Applicable federal rates (AFRs)

Every month the IRS releases interest rates for short-term, mid-term, and long-term loans:

• Short-term: 3 years or less
• Mid-term: more than 3 but less no more than 9 years
• Long-term: more than 9 years

These rates are used for various purposes. For example, you usually must charge at least the AFR on loans (there are some exceptions). If you don’t, the loan is treated as a “below market loan,” resulting in phantom interest for you (the lender) to the extent of foregone interest. This is includible in your gross income.

AFRs may be found here.

Interest rates for valuing partial interests and annuities

IRS mortality tables are used when figuring the value of an annuity, an interest for life or a term of years, and a remainder or reversionary interest. The mortality tables are determined using 120% of the AFR for the mid-term rate in effect for the month in which the valuation date occurs. If the property being transferred is for a charitable contribution, you may elect to use the federal mid-term AFR in either of the two months preceding the month in which the valuation date occurs. The IRS has proposed regulations to update the mortality tables, which by law must be done every 10 years.

Interest rate on debt instruments arising out of a sale

If you sell property and receive deferred payments, there must be a minimum stated interest rate, equal to the lesser of the AFR (short-term, mid-term, or long-term as applicable; see above) or 9% compounded semiannually. If no interest rate is stated, this minimum rate is used to figure the portion of the payments treated as interest.

This minimum interest rate applies if the debt instrument (e.g., a promissory note) does not exceed a set amount, which is adjusted annually for inflation. So, the minimum interest rate is fixed by statute, but the size of the transaction that becomes subject to the minimum interest rule is adjusted. For 2022, the minimum interest rate applies if the principal does not exceed $6,289,500 ($4,492,500 for a cash method instrument where the seller and buyer both agree to use the cash method of accounting to report interest and, where applicable, gains).

Conclusion

If you are required to apply an IRS interest rate to a particular situation, be sure you’re using the right one. And watch for changes because the rates and other rules adjust at set periods.

Sources:  IR-2022-107; https://www.law.cornell.edu/uscode/text/26/7872; Rev. Proc. 2021-45