IRC Section 1274 is the rule that sets a floor on interest for most seller-financed property sales: if the note you take back charges less than the IRS’s Applicable Federal Rate (AFR), the tax code recalculates the deal as though it carried adequate interest, and both sides report the difference as Original Issue Discount (OID). For the seller, that converts what looked like sale price into ordinary interest income year by year. For the buyer, it creates an annual interest deduction but lowers the basis in the property. Section 1274 imputed interest is, in short, the mechanism that stops buyers and sellers from dressing up interest as principal.
What the Rule Actually Does to Your Deal
The tax play Section 1274 targets is straightforward. Set a zero or nominal interest rate, inflate the purchase price by roughly the interest you skipped, and the seller converts ordinary interest income into long-term capital gain while the buyer walks away with a bigger depreciable basis. Both sides come out ahead at the Treasury’s expense.
Section 1274 shuts that down by requiring every deferred-payment property sale to carry an adequate amount of interest. If it doesn’t, the IRS treats a portion of the stated principal as interest instead. The gap between the note’s face amount and its recalculated present value is OID, and both parties recognize that OID as interest over the life of the note, whether or not cash changes hands in a given year.
The practical result: the seller reports ordinary interest income each year on the OID and computes capital gain only on the true principal (the recalculated issue price, not the face amount). The buyer gets a matching annual interest deduction but takes a lower starting basis in the property, which shrinks future depreciation and increases gain on resale.
When Section 1274 Applies to Your Sale
Section 1274 reaches sales or exchanges of property where at least one payment is due more than six months after closing and the note does not carry adequate stated interest.1Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property A sale paid in full within six months never triggers these rules, regardless of the stated rate.
Both the note and the property generally have to be non-publicly traded. If either trades on an established securities market, a different OID regime applies. In practice, Section 1274 covers most seller-financed transactions involving commercial real estate, closely held businesses, partnership interests, and similar private assets.
The adequacy test compares the note’s stated principal to its “imputed principal amount,” which is the present value of all future payments discounted at the AFR. If the stated principal is larger than that present value, the note fails the test and Section 1274 kicks in.2Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property – Section: Imputed Principal Amount
Modifying an existing note can also restart the analysis. If the terms of a debt instrument change enough to be treated under the regulations as a new instrument exchanged for the old one, the modified note gets retested against the current AFR.3eCFR. 26 CFR 1.1001-3 – Modifications of Debt Instruments Changes to the interest rate, maturity date, or principal amount are the usual triggers.
Exemptions That Keep Many Deals Out
Section 1274(c)(3) carves several categories of transactions out of the rule entirely:4Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property – Section: Exceptions
- Total consideration of $250,000 or less. Related transactions are lumped together, so splitting a sale into two $200,000 contracts does not escape the rule.
- Sale of a principal residence by an individual, regardless of price or stated rate.
- Farm sales of $1,000,000 or less by an individual, estate, testamentary trust, qualifying small business corporation, or qualifying partnership.
- Personal-use property, such as a personal car, boat, or furniture not used in a trade, business, or investment activity.
- Publicly traded debt instruments or property, which fall under other OID provisions.
- Certain land transfers between related persons, which are governed by Section 483(e) up to $500,000 in stated principal.
A separate de minimis rule can zero out the OID even on a transaction otherwise inside Section 1274. If the total OID is less than one-quarter of one percent of the stated redemption price at maturity multiplied by the number of complete years to maturity, it is treated as zero.5Office of the Law Revision Counsel. 26 USC 1273 – Determination of Amount of Original Issue Discount On a $500,000 note maturing in five years, the OID would have to fall below $6,250 (0.25% × $500,000 × 5) to qualify.
Short-term debt instruments with a fixed maturity of one year or less are also excluded from annual OID inclusion, though other provisions can still apply.6Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount
How Imputed Interest Gets Calculated
Everything runs off the AFR. The IRS publishes new AFRs monthly based on average yields on U.S. Treasury obligations,7Internal Revenue Service. Applicable Federal Rates in three tiers matched to the term of the note:8Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property – Section: Determination of Applicable Federal Rate
- Short-term: notes maturing in three years or less.
- Mid-term: notes maturing in more than three years but not more than nine years.
- Long-term: notes maturing in more than nine years.
For March 2026, the annual AFRs are 3.59% (short-term), 3.93% (mid-term), and 4.72% (long-term).9Internal Revenue Service. Revenue Ruling 2026-6 You can use the rate in effect for the month your contract becomes binding or either of the two preceding months.
The Discount Math
When the stated rate falls below the AFR, the IRS recalculates the note’s issue price by taking the present value of every scheduled payment (principal and stated interest) discounted at the AFR compounded semiannually.2Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property – Section: Imputed Principal Amount That present value becomes the note’s issue price for tax purposes, and the gap between the issue price and the face amount is OID.
Suppose you sell a commercial building for $1,000,000 with seller financing on a seven-year note at 1% stated interest and the mid-term AFR is 3.93%. Discounting the scheduled payments at 3.93% compounded semiannually produces a present value well below $1,000,000. That gap is OID, and you report a portion of it as ordinary interest income every year of the note’s life, even though the buyer is only handing you 1% in cash.
Constant Yield Accrual
OID is not spread evenly. Both parties use the constant yield method, sometimes called economic accrual: each year’s OID equals the note’s adjusted issue price multiplied by the yield to maturity, minus any qualified stated interest paid that year. The adjusted issue price grows each year by the OID accrued, so recognized interest ramps up over the term.
Sale-Leasebacks and Abusive Situations
When the seller finances a property sale and then leases the same property back from the buyer, the discount rate rises to 110% of the AFR.10Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property – Section: 110 Percent Rate Where Sale-Leaseback Involved
For deals the IRS deems potentially abusive, the calculation changes more sharply: the issue price is set equal to the fair market value of the property, not to a discounted present value.11Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property – Section: Fair Market Value Rule in Potentially Abusive Situations The statute reaches tax shelters and transactions with nonrecourse financing, loan terms exceeding the property’s economic life, or other features flagged by Treasury regulations. Anchoring to fair market value removes any benefit from inflating the stated price.
Relief for Smaller Transactions
Section 1274A softens the impact for deals that aren’t large enough to justify the full compliance burden. Both thresholds are adjusted annually for inflation.12Internal Revenue Service. Revenue Procedure 2025-32
The 9% Cap
For any qualified debt instrument with stated principal of $7,462,600 or less (the 2026 threshold), the discount rate used to test adequacy and calculate OID cannot exceed 9% compounded semiannually, even if the actual AFR is higher.13Office of the Law Revision Counsel. 26 USC 1274A – Special Rules for Certain Transactions Where Stated Principal Amount Does Not Exceed 2,800,000 The cap only bites when AFRs climb above 9%, which hasn’t happened recently, but it protects sellers from extreme imputed interest in high-rate environments.
The Cash Method Election
A more valuable break applies to even smaller deals. When stated principal does not exceed $5,330,500 (the 2026 inflation-adjusted amount), the buyer and seller can jointly elect to account for interest on the cash basis rather than the accrual basis Section 1274 normally requires.12Internal Revenue Service. Revenue Procedure 2025-32 The election effectively removes the note from Section 1274, and both sides report interest only when cash is paid or received.14Office of the Law Revision Counsel. 26 USC 1274A – Special Rules for Certain Transactions Where Stated Principal Amount Does Not Exceed 2,800,000 – Section: Election to Use Cash Method The lender cannot use an accrual method of accounting and cannot be a dealer in the type of property sold, and both parties must make the election jointly.
This is the provision that matters most to typical seller-financed deals. A small business owner selling a company for $3 million with seller financing can avoid annual OID accruals entirely by making the election, provided the other requirements are met.
How You Report It
Both parties have annual obligations that begin the moment OID exists on the note, regardless of cash flow.
The seller reports accrued OID as ordinary interest income each year. If the OID includible in gross income for the year is at least $10, the seller must issue Form 1099-OID to the buyer.15Internal Revenue Service. About Form 1099-OID, Original Issue Discount When the note also carries qualified stated interest (the portion that does meet the AFR), the seller can report both amounts on Form 1099-OID or split them between Form 1099-OID and Form 1099-INT.16Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
The buyer claims a matching interest deduction for the accrued OID each year, subject to the usual limits on interest deductions (investment interest limits, passive activity rules, and so on). The buyer’s basis in the property equals the note’s issue price after the Section 1274 adjustment, not the stated face amount. Higher imputed interest means a lower starting basis, which reduces future depreciation and increases gain on eventual resale.
The seller’s amount realized is similarly reduced by the imputed interest component. Capital gain is computed only on the true principal (the recalculated issue price) rather than the face amount of the note.
These obligations apply even to zero-coupon notes where no cash changes hands until maturity. The seller owes tax on phantom income each year, which can create a cash-flow squeeze that catches first-time seller-financiers off guard.
The Net Investment Income Tax Surprise
Imputed interest counts as investment income, so it can trigger the 3.8% Net Investment Income Tax. The NIIT applies to individuals with modified adjusted gross income above $200,000 (single filers) or $250,000 (married filing jointly), thresholds that are not indexed for inflation.17Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
Interest is one of the categories the NIIT reaches, alongside dividends, capital gains, rental income, and passive business income. Imputed interest from a seller-financed deal falls squarely within it. A seller who finances a $2 million property sale at a low rate can see tens of thousands of dollars in annual imputed interest income, all of which may face an additional 3.8% on top of ordinary income tax rates. Sellers routinely overlook this cost when structuring deferred-payment transactions.
Penalties for Getting It Wrong
Underreporting imputed interest income triggers the accuracy-related penalty of 20% of the underpayment when the IRS attributes the error to negligence or a substantial understatement of income tax.18Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments An understatement is substantial when it exceeds the greater of 10% of the tax due or $5,000. The IRS treats failure to report income shown on an information return like Form 1099-OID as a strong indicator of negligence.
A seller who fails to file Form 1099-OID faces separate per-form penalties based on how late the filing arrives:19Internal Revenue Service. Information Return Penalties
- Filed within 30 days of the deadline: $60 per form.
- Filed 31 days late through August 1: $130 per form.
- Filed after August 1 or not filed at all: $340 per form.
- Intentional disregard: $680 per form.
These penalties apply per form and per year. A seller carrying a five-year note who never files a single 1099-OID could face five $340 penalties, plus the 20% accuracy-related penalty on any unreported income.
Where Section 1274 Stops and Other Rules Begin
Not every below-market arrangement is a Section 1274 problem. Section 483 covers unstated interest in seller-financed property sales that fall outside Section 1274’s reach; whenever Section 1274 governs, Section 483 steps aside.20Office of the Law Revision Counsel. 26 USC 483 – Interest on Certain Deferred Payments The main practical difference is timing: Section 483 recharacterizes a portion of each payment as interest when the payment is received, while Section 1274 forces annual OID accrual whether or not cash moves. For cash-method sellers, that distinction matters. Related-person land transfers up to $500,000 in stated principal fall under Section 483(e), and Section 1274 defers to that rule.21Internal Revenue Service. Publication 537 (2025), Installment Sales Above $500,000, Section 1274 takes over.
Family transactions that are loans rather than property sales are governed by Section 7872, not Section 1274. Section 7872 reaches gift loans, compensation-related loans, and any below-market loan structured to avoid federal tax. A $10,000 de minimis exception shields small family loans, but it disappears if the borrower uses the loan to buy income-producing assets like stocks or rental property.22Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates – Section: De Minimis Exception If a parent sells rental property to a child on a below-market note, Section 1274 governs because it’s a sale of property for a debt instrument. A straight cash loan from parent to child would sit under Section 7872 instead. Misidentifying which section controls leads to the wrong amount of income reported in the wrong year.