The Internal Revenue Service (IRS) has specified minimum rates of interest for several common farm transactions. There are minimum interest rates for seller financing and for loans of cash.
The minimum rate for most seller-financed transactions is 9%, or the "applicable federal rate," whichever is lower. However, there is a special 6% rate available for certain farm real estate transactions (discussed below). In general, the interest rules operate by requiring the parties to report interest as if the required rate had been paid from the borrower to the lender. Frequently this causes an unexpected tax burden on the buyer, seller or both.
The "applicable federal rate" fluctuates each month based on the interest rate paid on outstanding marketable obligations of the U.S. government. The rates are published each month in the Internal Revenue Bulletin and many financial periodicals. There are actually 12 different rates depending on the length of loan and the compounding method chosen.
The applicable federal rate is the lesser of the rate for the month of the seller-financed sale or the previous two months. For seller-financed sales for $2.8 million or less, the required rate cannot exceed 9% compounded semi-annually (9.2% compounded annually, 8.9% compounded quarterly, or 8.84% compounded monthly).
The required minimum interest rate for land sales of $500,000 or less (per year) between family members is 6% compounded semi-annually. Buildings, tile lines, fences, personal residences, etc. are not land and do not qualify for the 6% rate. They are subject to the "applicable federal rate" compounded semiannually.
Occasionally parents loan children money for little or no interest. The general rule requires them to charge the "applicable federal rate." However, there are two exceptions that eliminate the minimum interest requirement for many loans.
First, the interest rules do not apply to a loan between individuals for any day that the total outstanding loans between the individuals is $10,000 or less. This exception does not apply if the loan is directly attributable to the purchase or carrying of income-producing assets.
Second, if parents loan large amounts of cash to children at no interest, the investment income earned by the children is taxable to the parents. However, the amount of interest is limited to the borrower's net investment income on any day the total outstanding loans between the borrower and lender is $100,000 or less. For the purposes of this rule, if the borrower's net investment income is $1,000 or less, it is treated as if it were zero. Thus, if the total outstanding loans are $100,000 or less and the borrower's net investment income is $1,000 or less, the interest rules do not apply to the loans.