Section 1274(d) of the Internal Revenue Code is the provision that sets the Applicable Federal Rate, or AFR, which is the minimum interest rate the IRS expects to see on a debt instrument issued in exchange for property. If a seller-financed note carries a rate below the AFR, the IRS treats part of what looks like sale proceeds as interest income instead, which changes the tax picture for both the buyer and the seller.
The rest of Section 1274 builds the machinery around that rate: when it applies, how it recharacterizes a below-market note, and what gets carved out. Here is what you need to know before you sign or close a deal that involves a promissory note back to the seller.
The AFR Is Three Rates, Not One
The AFR comes in three tiers, matched to the length of the debt. A short-term rate covers instruments of three years or less. A mid-term rate applies to terms over three years but not more than nine. A long-term rate applies to anything longer than nine years.1Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property Each is derived from the average market yield on comparable-maturity Treasury obligations, so the AFR moves with the bond market.
The IRS issues a new revenue ruling every month with updated rates. Current and historical rulings live at irs.gov/applicable-federal-rates.2Internal Revenue Service. Applicable Federal Rates (AFRs) Rulings Because the numbers change monthly, check the current ruling before finalizing any note.
The Three-Month Lookback
You are not stuck with the AFR in effect the month you close. The regulations let you use the lower of two figures: the lowest AFR during the three months ending with the first month you had a binding written contract, or the lowest AFR during the three months ending with the closing month.3eCFR. 26 CFR 1.1274-4 – Test Rate With no binding written contract, you use the lowest rate from the three months ending with closing.
In a rising-rate environment, that lookback can meaningfully lower the bar your note has to clear.
When Section 1274 Applies
Section 1274 kicks in only when all three of these are true:
- Total payments under the debt instrument, plus any other consideration the seller receives, exceed $250,000.1Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
- At least some payments are due more than six months after the sale date.
- Neither the property nor the debt instrument is publicly traded.
The typical situation is a seller-financed sale of a business or commercial real estate, where the buyer signs a promissory note to the seller. Smaller deferred sales are not off the hook; they fall under the simpler rules of Section 483 instead.
How a Below-AFR Note Gets Recharacterized
Consider the problem the section is designed to solve. You sell a commercial building for $1 million and take back a 10-year note at 1% when the long-term AFR is much higher. Left alone, that structure converts what should be interest income (ordinary rates) into sale proceeds (capital gain rates) for the seller, and it shrinks the buyer’s interest deduction. The IRS calls that artificial and pulls the numbers back toward market.
The Adequate Stated Interest Test
Section 1274 discounts every future payment on the note back to the sale date using the AFR. That produces the imputed principal amount. If the note’s stated principal is at or below the imputed principal amount, the note passes, its issue price equals its face value, and nothing changes.4Office of the Law Revision Counsel. 26 U.S. Code 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
If stated principal is higher than imputed principal, the note fails. Its issue price drops to the imputed principal amount, and the gap between the stated redemption price and that imputed principal becomes Original Issue Discount (OID). OID is treated as interest no matter what the contract calls it.
OID Accrues Under the Constant Yield Method
OID does not spread evenly. Both parties use the constant yield method, which loads more OID into the early years. Each period, multiply the note’s adjusted issue price (original issue price plus all OID accrued so far) by the yield to maturity, then subtract any cash interest actually paid. The remainder is OID for that period and is added to the adjusted issue price for the next calculation.
For the lender, each year’s OID is ordinary interest income, taxable even though no cash has changed hands. For the borrower, the same amount is generally deductible as interest expense if the interest would otherwise qualify. Both parties report OID annually regardless of their usual method of accounting. This is where seller-financed deals become expensive to administer: someone runs this calculation every year until the note is paid off.
Deals That Are Carved Out
Several transactions fall outside Section 1274 entirely:
- Debt instruments from the sale of an individual’s principal residence.1Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
- Sales of personal-use property, meaning property not used in a trade or business or for income production as of the date the note is issued.5Legal Information Institute. 26 USC 1275(b)(3) – Definition of Personal Use Property
- Sales where total payments and other consideration do not exceed $250,000 (Section 483 applies instead).
- Sales of farms by individuals or qualifying small business entities where the total price does not exceed $1,000,000.
A parent seller-financing a home to a child does not face Section 1274 imputation if the home was the parent’s principal residence. Investment property and rentals do not qualify for either the principal residence or personal-use exemption.
The 9% and 6% Rate Caps
Even when Section 1274 applies, two caps can limit the test rate.
Section 1274A caps the discount rate at 9%, compounded semiannually, for a “qualified debt instrument,” defined as one with a stated principal amount not exceeding $2,800,000 (a base figure that adjusts annually for inflation).6Office of the Law Revision Counsel. 26 USC 1274A – Special Rules for Certain Transactions Where Stated Principal Amount Does Not Exceed $2,800,000 With current AFRs well below 9%, this cap has no practical effect unless rates climb higher.
Section 1274A also offers a cash-method election. When stated principal does not exceed $2,000,000 (also inflation-adjusted), the borrower and lender can jointly elect out of OID accrual and instead report interest on a cash basis, recognizing income and expense when payments are actually made. The lender cannot already use the accrual method and cannot be a dealer in the property sold. Confirm current dollar thresholds against the most recent IRS revenue procedure.
Family land sales get a lower cap. Under Section 483(e), when an individual sells land to a family member, the maximum test rate is 6%, compounded semiannually, but only if total sales between the same parties in the calendar year do not exceed $500,000.7Office of the Law Revision Counsel. 26 USC 483 – Interest on Certain Deferred Payments The rule covers land only, not buildings, and family is defined by the related-party rules in Section 267(c)(4).
Where 1274 Ends and Sections 483 and 7872 Begin
Three Code sections govern below-market interest, and they do not overlap.
Section 483 handles deferred-payment property sales where Section 1274 does not apply, generally deals of $250,000 or less. It treats below-market interest as “unstated interest” rather than OID, a simpler calculation. Sales priced at $3,000 or less are exempt from Section 483 as well.7Office of the Law Revision Counsel. 26 USC 483 – Interest on Certain Deferred Payments
Section 7872 covers below-market loans unconnected to a property sale, such as interest-free family loans or employer-employee loans. It explicitly does not apply to any transaction governed by Section 483 or Section 1274.8Office of the Law Revision Counsel. 26 U.S. Code 7872 – Treatment of Loans With Below-Market Interest Rates If your note is tied to property changing hands, you are in 1274 or 483 territory. If it is a personal loan with no property exchange, you are in 7872.
Annual Reporting
Once a seller-financed deal generates OID, the lender files Form 1099-OID each year the includible OID is $10 or more, sending a copy to the borrower and one to the IRS.9Internal Revenue Service. About Form 1099-OID, Original Issue Discount Paper filings are due by the end of February; electronic filings are due by March 31.
The borrower reports the OID amount on their return and, if the interest is deductible, claims the corresponding deduction. Both sides either run the constant-yield calculation themselves or rely on the 1099-OID. Because OID compounds and the adjusted issue price shifts every period, keep clean records from year one. Reconstructing several years of missed accruals during an audit is painful.
What Getting It Wrong Costs
Missing imputed interest exposes both sides to standard IRS penalties. The accuracy-related penalty under Section 6662 is 20% of the underpayment attributable to negligence, disregard of rules, or a substantial understatement of income. It doubles to 40% for a gross valuation misstatement.10eCFR. 26 CFR 1.6662-2 – Accuracy-Related Penalty
Failure to file a return reporting the income triggers a late-filing penalty of 5% of the unpaid tax per month, capped at 25%. A separate late-payment penalty of 0.5% per month applies to tax shown on a return but not paid, also capped at 25%. Interest runs on the unpaid balance on top of those.
The lender faces a separate penalty for failing to file Form 1099-OID, under the standard information-return rules. None of these penalties requires intent. Not knowing about imputed interest is enough to owe them.