Seller Note Interest: AFR, Imputed Interest and How It Is Taxed

How installment sale interest works

Every payment on a seller note has up to three parts: interest, return of your basis, and gain. Only the gain part uses the installment method and the gross profit ratio. The interest part is ordinary income in the year it is received (or accrued, for original issue discount). If the note's stated rate is too low, the tax law does not let the price absorb the interest. Sections 483 and 1274 carve imputed interest out of the principal, which lowers your selling price and capital gain and raises your ordinary income. That is why the rate on the note matters for seller financing taxes, not just for your yield. The gain side is covered on installment sale tax.

Section 1274 or Section 483: which one applies

Both test the note against the AFR. They differ in timing.

• Section 1274 applies to a debt instrument given for property when some payment is due more than 6 months after the sale and the stated interest is not adequate. The shortfall becomes original issue discount, which both sides accrue on a constant yield basis, even before cash is paid.
• Section 483 picks up contracts that Section 1274 excludes, when some payment is due more than 1 year after the sale. Unstated interest is taken into account when payments are made. Section 1274(c)(3) sends these to Section 483: farms sold by individuals or small businesses for $1,000,000 or less; an individual's sale of a principal residence; sales where total payments and other consideration are $250,000 or less; certain patent sales; and related-party land sales covered by Section 483(e).
• Neither applies to sales of $3,000 or less (Section 483(d)(2)).
• Section 7872 does not apply. The below-market loan rules are for loans, and Section 7872(f)(8) says they do not apply to any loan to which Section 483 or 1274 applies. A seller note is tested under 483 and 1274.

The AFR test rate and the lowest-of-3-months rule

The AFR class depends on the term: short-term for 3 years or less, mid-term for over 3 and up to 9 years, long-term for over 9 years (IRC 1274(d)(1)). For an installment note, the term is its weighted average maturity, not its stated maturity (Treas. Reg. 1.1274-4 and Publication 537). A 30-year amortization with a 7-year balloon has a weighted average maturity near 6.6 years, so it uses the mid-term rate.

For any sale or exchange, IRC 1274(d)(2) lets you use the lowest AFR in effect during the 3 calendar months ending with the first month there is a binding written contract. Treas. Reg. 1.1274-4(a)(1) adds the alternative window ending with the month of the sale, and you use whichever is lower. Use the column matching the note's payment frequency: monthly payments, monthly compounding.

Sources: Rev. Rul. 2026-13, 2026-17 and 2026-19. On an annual compounding basis, October 2026 is 4.25% short, 4.61% mid and 5.22% long. For a contract signed in October 2026, the floor is the August rate: 4.26% for a mid-term note and 4.81% for a long-term note. The IRS publishes new rates each month, in the second half of the prior month, on its Applicable Federal Rates page.

Section 1274A: the 9% cap, the cash method, and 2026 thresholds

• Qualified debt instrument. If the note's stated principal is $7,462,600 or less in 2026 (Rev. Proc. 2025-32), the test rate cannot exceed 9%, compounded semiannually (IRC 1274A(a) and (b)). It only matters when the AFR is above 9%, which it is not today. The cap does not cover new Section 38 property, which includes most depreciable tangible personal property.
• Cash method election. If stated principal is $5,330,500 or less in 2026, the seller is on the cash method and not a dealer, and buyer and seller jointly elect, Section 1274 does not apply and both report interest on the cash method (IRC 1274A(c)). The election binds successors to the note.
• Related-party land, 6%. For a sale of land by an individual to a family member (IRC 267(c)(4)), the test rate under Section 483 is capped at 6%, compounded semiannually, for up to $500,000 of sales price per calendar year between the same individuals. It does not apply if either party is a nonresident alien (IRC 483(e)). See related party installment sales.
• Sale-leaseback, 110%. If the seller or a related person leases back part of the property under a plan, the test rate is 110% of the AFR and the 1274A cap does not apply (IRC 1274(e)). See sale-leaseback.

How the interest is taxed to you

Interest on a seller note is ordinary income at your regular bracket. It never gets the 0%, 15% or 20% capital gain rates. It is investment income for the 3.8% net investment income tax under IRC 1411(c)(1)(A)(i), which applies when modified adjusted gross income is over $200,000 single or $250,000 married filing jointly. States generally tax it as ordinary income; California, for example, taxes it at regular rates for residents. If you move, interest on an intangible note generally follows your residence, while the gain on real property stays sourced to the state where it sits. See California installment sale tax.

Example from our engine (assumptions: $960,000 note at 6.5%, 30-year amortization, 7-year balloon, married filing jointly, $120,000 of other income, no state income tax, 2026): $417,696 of interest over 7 years, $62,084 of it in year one. The engine attributes $17,259 of year-one tax and $100,329 of total tax to that interest. Run your numbers to see it for your note.

Report interest on Schedule B. If the buyer used the property as a home, list the buyer's name, address and SSN, and give the buyer yours; the buyer needs it to deduct the interest.

Can the buyer deduct the interest?

It depends on what the buyer does with the property. Interest on a note for business or rental property is generally deductible as a business expense (larger businesses face the Section 163(j) limit). Interest on investment property is investment interest under Section 163(d). For a home, the buyer can deduct qualified residence interest only if the seller note is secured by the home, within the acquisition debt limits. For personal-use property, Publication 537 says the buyer cannot deduct unstated interest or original issue discount, while the seller must still report it.

Getting the rate right before closing

Pick the rate after you know the term class and the contract month. Price above the floor to reflect the buyer's credit: the AFR is a tax minimum, not a market rate for a private note. A higher rate raises your ordinary income each year. A lower rate within the rules leaves more of the price as capital gain. Put the rate, compounding and payment dates in the note itself. The rest of the reporting is on the Form 6252 reporting page, and recapture is on depreciation recapture on an installment sale. Get the full Big Sale Tax Analysis to see the rate choice modeled against a cash sale, a 1031 and the other paths.

Get the full Big Sale Tax Analysis

Frequently asked questions