When you carry a note on property you sell, federal tax rules expect the note to charge at least a minimum rate, generally tied to the applicable federal rate (AFR) the IRS publishes each month. If the note charges less, part of each payment can be treated as interest anyway. That is imputed interest. This page is general information, not tax advice, so set the rate with a CPA before you sign.
Most seller-financing rate questions start with what the buyer can afford or what a bank would charge. There is a tax floor underneath both, and it catches family sales, zero-interest deals and notes written without advice. Here is how it works in plain terms, and where it sits beside the other rules on the rate, as part of the note basics on this site.
What the applicable federal rate is
The applicable federal rate is a set of interest rates the IRS publishes every month in a revenue ruling. The rates follow the yields on US Treasury debt, so they rise and fall with the wider market. There are three main bands, picked by the length of the note:
| AFR band | Note term |
|---|---|
| Short-term | Three years or less |
| Mid-term | Over three years, up to nine years |
| Long-term | Over nine years |
Each band is published with different compounding periods, monthly, quarterly, semiannual and annual. The current tables are on the IRS website, and we do not quote a rate here because it changes every month. For a sale, the rules generally let you use the lowest AFR in effect during a three-month window ending with the month the binding written contract was signed. Ask your CPA which month’s table applies to your deal.
The rules that impute interest
Several sections of the Internal Revenue Code deal with notes that charge too little. Which one applies depends on what the note was given for and on the size of the deal.
IRC 1274: debt given for property
Section 1274 covers notes issued in exchange for property, which is what a seller-financed note is. If the note’s stated interest is below the test rate, the rules work out a lower principal amount by discounting the payments at the AFR. The difference between that figure and the payments becomes interest, reported over the life of the note under the original issue discount rules.
IRC 483: the smaller and personal sales
Section 483 picks up many sales that fall outside 1274, including smaller sales, sales of a principal residence and certain farm sales. It reaches a similar result in a simpler way: part of each deferred payment is treated as unstated interest. Section 1274A and related provisions set lower caps on the test rate for some sales, including certain sales of land between family members. Some of these limits come with dollar figures, and some are adjusted each year, so check them with your adviser rather than relying on a number you have read.
IRC 7872: below-market loans of money
Section 7872 is the rule people often have in mind, but it is aimed at loans of cash, such as a parent lending a child money at no interest. A note given in a property sale usually falls under 1274 or 483 instead. If your deal mixed a loan of cash with a sale, raise 7872 with your CPA.
What imputed interest does, with numbers
Say you sell a piece of land, take a down payment and carry a $100,000 note with no interest, paid at about $833 a month over ten years. Suppose, for illustration only, that the test rate for the note is 4%. Discounting the 120 payments at 4% gives a present value of about $82,300.
- The tax rules treat about $82,300 as the principal of the note, and so as part of your sale price.
- The remaining $17,700 or so is treated as interest, spread over the ten years, with about $3,170 of it in the first year.
- Your sale price, and the gain on the property, are lower by that $17,700 for tax purposes.
The 4% rate is a made-up figure for the example, not a current AFR. The point is the shape of the effect: no money changes hands differently, but some of what you thought of as sale price is taxed as interest, which is generally ordinary income. Your buyer’s tax basis in the property is lower by the same amount. Whether that costs or saves you anything depends on your other income and how the gain on the sale would have been taxed, which is why the answer has to come from a CPA.
The other limits on the rate
The AFR is a floor for tax purposes. It is one of several rules that bear on the rate you write into a note.
- State usury law sets the maximum interest a lender may charge, and the limits and exemptions vary by state.
- Federal lending rules under Dodd-Frank and Regulation Z can apply to seller financing of a home and affect whether the rate can adjust. Seller financing rules in plain English is the place to start.
- The market is what a future buyer of the note will measure your rate against, which matters if you might sell it.
An attorney who handles real estate closings can check the usury and lending side, and a CPA the tax side. The note should satisfy both before anyone signs.
The rate, the AFR and selling the note later
A rate set at the bare AFR keeps the tax rules quiet, but it can still be well below what a note buyer needs. A buyer measures a note by the return on the price paid, and the lower the rate, the further the price falls below the balance. That relationship is set out in how the interest rate affects your note’s value. If you already hold a note at 0%, the buyer’s view of it, and what you can do about the discount, is on the page about selling a note that charges no interest.
When the note is sold, the imputed interest question does not vanish. How much interest has been treated as earned so far affects your basis in the note and so the gain on the sale, a calculation tied to the rules in installment sale tax when you sell a note. If you are weighing a sale of a low-rate note, send us the note’s terms and take the figures that come back to your CPA together with your past returns.
Reporting and record keeping
If interest is imputed, it is reported each year whether or not the note says interest is being paid. The holder reports it as interest income, and the payer may be able to treat it as interest paid. Both sides do better with a written schedule that shows the imputed split for each payment, prepared once at the start. The year-end forms are covered in interest reporting for private note holders.
Questions to settle before you sign
- Which AFR band does this note’s term fall into, and which month’s table applies?
- Does the sale fall under section 1274 or section 483, and does any lower cap apply?
- If we choose a rate below the AFR, what is the imputed interest each year for both sides?
- Does the rate pass the usury limit in the state where the property is?
- If I may sell the note later, how will a buyer see this rate?
Ask those before closing, because a rate is far easier to set well than to fix afterwards, and once the note is signed the terms bind both you and your buyer for years.
Related questions
Can I sell property with a zero-interest note?
You can, but tax rules may treat part of each payment as interest anyway, under IRC 1274 or IRC 483. That shifts part of your sale price into interest income. Ask a CPA before you sign.
Where do I find the current AFR?
The IRS publishes the applicable federal rates each month in a revenue ruling, with short-term, mid-term and long-term bands. Your CPA can tell you which band and which month's table applies to your note.
Does charging the AFR make my note easy to sell?
Not necessarily. The AFR is a tax floor, and a note buyer measures your rate against the return they need. A rate near the AFR may still mean a sizeable discount when you sell.