Seller Financing Interest Rate: AFR Minimum and Imputed Interest
For tax purposes, a seller-financed note should charge at least the applicable federal rate (AFR) for its term. If it charges less, or nothing, the tax law treats part of each principal payment as interest (IRC §§483 and 1274). That moves income from capital gain into ordinary interest, and on larger notes it can make you report interest income years before you are paid.
The AFR is a floor for tax, not a pricing guide. The rate you actually negotiate depends on the buyer, the collateral and the market. The IRS publishes the rates each month; see the AFR revenue ruling index rather than relying on any rate quoted in an article, which goes stale within weeks.
Short answer: charge at least the AFR
A note has "adequate stated interest" if its stated principal is no more than the present value of all its payments, discounted at the test rate (the AFR), compounded semiannually (§1274(b)(2)(B), (c)(2)). In plain terms: if your stated rate is at least the AFR for the note's term, compounded semiannually, you are generally fine.
IRS Pub. 537 puts it this way: an installment sale contract "doesn't provide for adequate stated interest if the stated interest rate is lower than the test rate."
What happens if you charge less
If the note falls short, one of two Code sections recharacterizes part of the principal as interest:
- §1274 (original issue discount, OID) applies to larger sales. The shortfall is OID, and you include it in income over the life of the note on a constant yield basis, even if you are a cash-method seller and even in years you receive no payment. (For notes under an inflation-adjusted size limit, a cash-method seller and the buyer can jointly elect cash-method treatment under §1274A(c); ask your CPA.)
- §483 (unstated interest) applies to many smaller sales and sales exempt from §1274. The unstated interest is included under your regular accounting method, generally when payments arrive.
Either way, per Pub. 537, you "reduce the stated selling price of the property and increase your interest income." Less gain, more ordinary income.
Which one applies?
| Sale | Rule that applies | Source |
|---|---|---|
| Total payments of $250,000 or less | §483, not §1274 | §1274(c)(3)(C) |
| Sale of an individual's main home | §483, not §1274 | §1274(c)(3)(B) |
| Farm sold for $1,000,000 or less by an individual, estate, testamentary trust or qualifying small business | §483, not §1274 | §1274(c)(3)(A) |
| Land sold to a family member, up to $500,000 of sales price per year between the same individuals | §483, with the test rate capped at 6% compounded semiannually | §483(e) |
| Sales price that cannot exceed $3,000 | Neither | §483(d)(2) |
| No payment due more than 1 year after the sale | §483 does not apply | §483(c)(1) |
| Most other sales with payments due more than 6 months out | §1274 | §1274 |
The 9% cap. For seller financing up to an inflation-adjusted amount, the test rate cannot exceed 9%, compounded semiannually (§1274A). Pub. 537 (for 2025 returns) lists that amount as $7,296,700, and the cap does not apply to most depreciable tangible personal property. It matters only when the AFR itself is above 9%.
Short, mid and long-term AFR: which applies
The AFR depends on the note's term (§1274(d)(1)):
| Note term | AFR used |
|---|---|
| 3 years or less | Federal short-term rate |
| Over 3 years, up to 9 years | Federal mid-term rate |
| Over 9 years | Federal long-term rate |
For an installment note, the "term" is its weighted average maturity (Pub. 537, citing Reg. §1.1273-1(e)(3)), not simply the final due date. A 15-year amortizing note can have a weighted average maturity well under 15 years.
Which month's rate. Under §1274(d)(2), a sale uses the lowest AFR in effect during the 3-calendar-month period ending with the first month in which there is a binding written contract. Pub. 537 adds that you may use the lower of that 3-month rate or the 3-month rate ending with the month the sale closes. That gives you a small window: if rates are rising, the contract month can lock a lower floor.
Worked example: 0% note vs an AFR note
Simple example. The 4.0% rate below is an assumed AFR chosen for round arithmetic, not a current rate. Married filing jointly, $120,000 of other ordinary income, standard deduction, 2026 federal brackets held flat (Rev. Proc. 2025-32). The land is held for investment, so the gain and interest are net investment income.
You sell investment land with a $200,000 basis for $500,000. The buyer pays $100,000 down and owes $400,000 in one balloon payment at the end of year 5, with no interest. Total payments exceed $250,000, so §1274 applies.
What the IRS sees. Discount the $400,000 at the assumed 4.0% AFR, compounded semiannually, for 10 half-years: $400,000 / 1.02^10 = $328,139. That is the note's real principal. The other $71,861 is OID, which is interest.
| As written (0% note) | As the tax law treats it | |
|---|---|---|
| Selling price | $500,000 | $428,139 |
| Gain on the sale | $300,000 | $228,139 |
| Gross profit percentage | 60% | 53.29% |
| Interest income over 5 years | $0 | $71,861 |
OID is included every year, cash or no cash. Using the constant yield method at 2% per half-year:
| Year | Cash received | Gain reported | OID interest reported |
|---|---|---|---|
| 1 | $100,000 | $53,286 | $13,257 |
| 2 | $0 | $0 | $13,792 |
| 3 | $0 | $0 | $14,350 |
| 4 | $0 | $0 | $14,929 |
| 5 | $400,000 | $174,853 | $15,532 |
| Total | $500,000 | $228,139 | $71,861 |
Federal tax on the sale (income tax plus 3.8% NIIT), simple example:
| Year | If the 0% note were respected | As recharacterized |
|---|---|---|
| 1 | $7,335 | $9,609 |
| 2 | $0 | $1,734 |
| 3 | $0 | $1,857 |
| 4 | $0 | $1,984 |
| 5 | $38,515 | $30,640 |
| Total | $45,850 | $45,824 |
What this shows. In this example the total federal tax barely changes: the recharacterized interest is taxed at 22% instead of 15%, but it also lowers the year-5 gain enough to keep more of it under the 3.8% line. The bigger practical effects are:
- Tax with no cash. Years 2 to 4 carry tax on interest you have not received.
- Character. $71,861 moved from capital gain to ordinary income. With capital losses or a lower bracket for gain, that can cost more.
- Records. You and the buyer need an OID schedule, and the buyer's basis and interest deductions change too.
With other income, brackets or state tax, the answer can swing either way. The simple fix is a stated rate at or above the AFR from the start.
Interest is ordinary income; principal is gain
Every payment on a seller-financed note has up to three parts (Pub. 537): interest, a tax-free return of basis, and gain. Interest is always ordinary income and is reported separately from Form 6252. Principal is split by the gross profit percentage into basis and gain. See the seller financing taxes guide for the full breakdown.
Three points about the interest:
- It is portfolio income. Passive losses from rentals cannot offset it (Temp. Reg. §1.469-2T(c)(3)).
- It is net investment income for the 3.8% tax.
- If you sold a home the buyer lives in, report the buyer's name, address and SSN with the interest on Schedule B, and give the buyer your SSN. The buyer puts your information on Schedule A to deduct it. Pub. 537 notes a penalty if either side leaves out the other's number.
Market rate vs AFR: pricing the note for the buyer
The AFR only sets the tax floor. A seller who is taking the buyer's credit risk usually charges more, and the negotiation is a trade-off:
- Higher rate: more ordinary interest income for you, higher payments for the buyer.
- Higher price, lower rate: more capital gain, less interest, and a buyer who may be happy with a lower payment. Keep the rate at or above the AFR, or part of that price becomes interest anyway.
- Related parties: below-market loans to family raise separate gift and below-market loan issues. Pub. 537 notes that when a debt is subject to both §483 and the below-market loan rules (such as a gift loan), the below-market loan rules apply instead. See related-party installment sales.
To see how the rate changes the payment, the interest income and the tax each year, run the seller financing calculator. The installment sale guide covers the rest of §453.
Bottom line
Set the note's stated rate at or above the AFR for its term, measured in the month of the binding contract. Charge less and part of your price is taxed as ordinary interest, sometimes years before you collect it. Check the IRS's monthly AFR rulings when you sign, and let the market, not the AFR, set the rest of the rate.
Questions to ask your CPA
- Does §483 or §1274 apply to my sale, given the price and the type of property?
- What is my note's weighted average maturity, and which AFR does that point to?
- Which month's AFR can I use, the contract month or the closing month?
- If the rate is below the AFR, what will I report as interest each year, and when?
- Is my buyer related to me, and do the related-party land or below-market loan rules apply?
- How does the interest affect my 3.8% tax, Medicare premiums and estimated payments?
Run your own numbers. Compare a cash sale, seller financing and a structured installment sale side by side, free.
Educational only, not tax, legal or investment advice. Examples are illustrative. Have your CPA or tax attorney review your facts before you act. Hans Goldstein is a licensed insurance agent (CA Insurance License #4273294) and is not a CPA or attorney. He is paid a commission only if a structured installment sale is funded; seller financing pays him nothing. Disclosures.