What Is the Difference Between AFR and Adjusted AFR?

The Applicable Federal Rate (AFR) is the minimum interest rate the IRS requires on taxable private loans and seller-financed sales, and the Adjusted AFR is a lower version of those same rates used for tax-exempt obligations like municipal bonds. The difference between AFR and Adjusted AFR shows up plainly in the monthly numbers. For March 2026, the long-term AFR is 4.72% at annual compounding, while the adjusted long-term rate for the same month is 3.58%.¹ Both sets of rates are published together each month in the same short-term, mid-term, and long-term tiers, but they answer different questions for different taxpayers.

What the Standard AFR Is

The AFR comes from Internal Revenue Code Section 1274(d), which directs Treasury to determine three benchmark rates each month based on average yields of U.S. Treasury securities.² Because Treasury yields reflect what the federal government itself pays to borrow, the AFR functions as a floor for what private lenders should charge. Lend money to a relative or finance a property sale below the AFR, and the IRS treats the shortfall as either a taxable gift or phantom interest income the lender owes tax on, even though no cash changed hands.

The rates split into three tiers by term:

Short-term: three years or less.
Mid-term: more than three years but not more than nine.
Long-term: more than nine years.

Each tier is published with four compounding options: annual, semiannual, quarterly, and monthly. More frequent compounding produces a slightly lower stated rate, because the interest itself earns interest more often. For March 2026, the short-term AFR runs from 3.59% (annual) down to 3.55% (monthly), the mid-term from 3.93% to 3.87%, and the long-term from 4.72% to 4.63%.¹

What the Adjusted AFR Is and Why It’s Lower

The Adjusted AFR exists because some debt obligations, most commonly municipal bonds, pay interest that is exempt from federal income tax. When interest is tax-free, a lower stated rate delivers the same after-tax return as a higher taxable rate. Section 1288(b)(1) directs Treasury to adjust the AFR downward for this reason when calculating original issue discount and unstated interest on tax-exempt obligations.³

So each month the IRS publishes two parallel sets of rates. The standard AFR applies to taxable transactions. The Adjusted AFR applies to tax-exempt bonds and a handful of related calculations. For March 2026, the adjusted short-term rate is 2.72%, the adjusted mid-term is 2.97%, and the adjusted long-term is 3.58%, each roughly 25% to 30% below its standard AFR counterpart.¹

Treasury does not pick the discount by feel. Under final regulations issued in 2016, the standard AFR is multiplied by an adjustment factor calculated as 100% minus the product of a combined tax rate and a fixed 59%. The combined tax rate sums the highest individual income tax rate under Section 1 and the net investment income tax rate under Section 1411.⁴ That formula produces a consistently lower rate that reflects the built-in federal tax advantage of tax-exempt interest.

Which Rate Applies to Your Situation

Standard AFR: Private Loans and Seller Financing

If you are lending money to a family member, to your own business, or to an employee, the standard AFR is the number you care about. Section 7872 treats any below-market loan as if it had two parts: a deemed transfer from lender to borrower (gift or compensation) and a deemed retransfer of imputed interest back to the lender. The lender owes income tax on the imputed interest, and the deemed gift can count against the lender’s lifetime gift tax exemption if it exceeds the $19,000 annual exclusion.⁵⁶ Charging at least the AFR for the correct term and compounding period avoids the problem entirely.

Two safe harbors soften the rule for smaller loans. If the total outstanding balance between two individuals stays at or below $10,000, the below-market loan rules do not apply, unless the money is used to buy or carry income-producing assets. For gift loans between $10,001 and $100,000, the imputed interest the lender must report is capped at the borrower’s actual net investment income for the year, and is treated as zero if that investment income is $1,000 or less. The cap disappears if a principal purpose of the arrangement is tax avoidance.⁵

Seller-financed property sales run on the same standard AFR through Section 1274. If the installment note’s rate falls short of the AFR, the IRS recharacterizes part of each principal payment as disguised interest, shifting income between buyer and seller. Sales of farms by individuals or small businesses are exempt if the price does not exceed $1,000,000, and any sale where total payments do not exceed $250,000 falls outside Section 1274 entirely.²

Standard AFR: Estate Planning

Estate planners also work off the standard AFR. In a sale to an intentionally defective grantor trust, the grantor sells appreciated assets to the trust in exchange for a promissory note charging the AFR; any growth above the AFR passes to beneficiaries free of gift and estate tax. A related figure, the Section 7520 rate, is set at 120% of the federal mid-term AFR, rounded to the nearest two-tenths of a percent, and is used to value annuities, life estates, and charitable remainder trusts. For January 2026, the Section 7520 rate was 4.6%.⁷

Adjusted AFR: Tax-Exempt Bonds and Section 382

The Adjusted AFR reaches a narrower audience. Its primary role is calculating original issue discount on tax-exempt bonds, most commonly municipal bonds issued for public infrastructure, schools, and other government projects. When a tax-exempt bond is issued at a discount, the holder accrues that discount over the life of the bond, and the Adjusted AFR supplies the correct discount rate so the IRS does not overstate the economic gain by applying a taxable benchmark to tax-free income.³

The Adjusted AFR also feeds Section 382, which caps how much of a corporation’s pre-acquisition net operating losses the acquiring company can use each year after an ownership change. The annual limit equals the value of the loss corporation multiplied by the adjusted federal long-term rate, so a higher adjusted rate lets the acquirer absorb more of the old losses.⁴ Most individual taxpayers will never use the Adjusted AFR directly. Anyone holding municipal bonds in a taxable account should know that their basis math runs through it.

Picking the Right Month’s Rate

AFR rates change every month, so timing matters. For debt instruments issued in connection with a sale or exchange of property, Section 1274(d)(2) lets you use the lowest AFR from the three-calendar-month period ending with the first month in which there is a binding written contract.² Sign a binding contract in March 2026 and you can choose the lowest rate from January, February, or March. Over a large note in a falling-rate environment, the difference is real money.

Direct loans under Section 7872, such as family loans and employer-employee loans, have no comparable three-month lookback. The rate is generally set when the loan is funded, so the month you disburse determines the number you’re locked into.

What Happens If You Get the Rate Wrong

Understate the interest on a loan and the IRS can impose a 20% accuracy-related penalty on the resulting underpayment. That penalty rises to 40% for gross valuation misstatements.⁸ On a large loan where thousands in imputed interest went unreported, back taxes, interest, and penalties add up quickly. A written promissory note that specifies the AFR used, the compounding period, and the payment schedule is the cleanest way to show the IRS the correct rate was charged.

1
Internal Revenue Service. Revenue Ruling 2026-6 – Applicable Federal Rates for March 2026
2
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
3
Office of the Law Revision Counsel. 26 USC 1288 – Treatment of Original Issue Discount on Tax-Exempt Obligations
4
Internal Revenue Service. Determination of Adjusted Applicable Federal Rates Under Section 1288 and the Adjusted Federal Long-Term Rate Under Section 382
5
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
6
Internal Revenue Service. Gift Tax
7
Internal Revenue Service. Section 7520 Interest Rates
8
Office of the Law Revision Counsel. 26 US Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments