Seller Financing: Applicable Federal Rates and Imputed Interest Risk

When a seller finances part of the purchase, the note's interest rate must meet the IRS's applicable federal rate (AFR). Below-market rates trigger imputed interest that both parties must recognize—creating phantom income taxes neither party expected. AFR verification is essential before closing.

Interest rate must meet the applicable federal rate. Under Sections 1274 and 7872, if the stated interest rate on a seller note is below the IRS-published applicable federal rate (AFR), the IRS imputes additional interest. This means both you and the seller may owe tax on "phantom" interest income that was never actually paid. Your CPA must verify the rate meets AFR at the time the note is executed.

Installment sale treatment benefits the seller. Under Section 453, the seller recognizes gain proportionally as payments are received rather than all at once. This is a seller benefit, but it also means the seller has a financial incentive to offer financing -- which can be a negotiating lever for you.

Your interest payments are deductible. As with bank financing, interest on seller-financed acquisition debt is deductible under Section 163, subject to the same 163(j) limitations.

The pitfall: Agreeing to a below-market interest rate without understanding that the IRS will impute interest anyway. You do not save money -- you just create extra reporting complexity and potential penalties for both parties.