Do You Have to Charge Interest on a Contract for Deed?

You aren’t legally required to charge interest on a contract for deed, but if you don’t charge enough, the IRS will act as though you did. When charging interest on a contract for deed, the floor you need to meet is the Applicable Federal Rate (AFR) published each month by the IRS, and for most residential seller-financed sales the test rate is capped at 9 percent compounded semiannually. Fall below the AFR and the IRS retroactively splits every payment into principal and imputed interest, which raises the seller’s tax bill and changes the buyer’s basis in the property.

Why the IRS Cares About the Rate

A contract for deed is a seller-financed sale: the buyer pays the seller directly and the seller keeps legal title until the balance is paid off. Because the seller is effectively lending the purchase price, the IRS treats the arrangement like a loan and expects interest to be part of it. Without that expectation, a seller could roll what should be taxable interest income into the purchase price and pay the lower capital gains rate on the whole amount.

To close that door, the Internal Revenue Code uses Sections 1274 and 483 to recharacterize part of the stated principal as interest whenever a contract lacks an adequate stated rate. The IRS calls this “unstated interest” or “original issue discount.” Either way, the practical result is the same: each payment gets split into a principal portion and an interest portion whether the contract does so or not.¹

The Applicable Federal Rate Is Your Floor

The minimum rate to charge is the AFR in effect during the month you sign the contract. The IRS publishes new AFRs monthly as revenue rulings, in three tiers based on how long the contract runs:

Short-term: three years or less
Mid-term: more than three years, up to nine years
Long-term: more than nine years

For reference, the April 2026 AFRs for annual compounding were 3.59 percent short-term, 3.82 percent mid-term, and 4.62 percent long-term.² Rates change every month, so check the current figure before signing. The IRS keeps a page linking to each monthly ruling.³

Most contracts for deed run longer than nine years, so the long-term AFR is usually the one that matters. Setting your rate at or above that month’s AFR satisfies the IRS for the full life of the contract, even if market rates climb later.

The 9 Percent Ceiling on the Test Rate

The test rate for adequate stated interest can’t exceed 9 percent compounded semiannually for what the IRS calls a “qualified debt instrument.” A debt instrument qualifies when the stated principal doesn’t exceed a threshold that started at $2,800,000 and adjusts annually for inflation.⁴ Nearly every contract-for-deed sale falls under that ceiling.

In normal rate environments this cap is background: when AFRs sit well below 9 percent, the AFR is your floor and the cap doesn’t come into play. If long-term AFRs ever pushed above 9 percent, the test rate for a qualifying sale would stay at 9 percent, so neither side would be measured against an unusually high benchmark.

Family Land Sales Get a Lower Floor

Selling land to a family member comes with a more forgiving test rate. Under Section 483(e), the test rate for a sale of land between family members can’t exceed 6 percent compounded semiannually, regardless of the AFR that month. A parent selling a parcel to a child can charge 6 percent even if the long-term AFR is higher.⁵

Two limits apply. The rule covers only land, not improved structures sold separately from the underlying parcel. And the total price of all qualifying sales between the same two family members in a calendar year can’t exceed $500,000. Anything above that goes back to the standard AFR test. Sales involving a nonresident alien don’t qualify.

Even at the reduced rate, interest you don’t charge on a family sale can create gift tax exposure. The IRS treats a below-market loan between family members as a gift equal to the forgone interest. If that amount exceeds the $19,000 annual gift tax exclusion for 2026, the seller may need to file a gift tax return on Form 709.⁶

What Happens If You Charge Too Little

Charge below the AFR and the IRS retroactively splits every payment into a principal piece and an imputed interest piece. Both sides feel it.

For the seller, income shifts from capital gains into ordinary income. You still receive the same dollars, but a slice of what you expected to report as gain on the sale gets reclassified as interest income, which is taxed at ordinary rates. The IRS also reduces the stated selling price by the amount of imputed interest, which changes the gain calculation on the installment sale itself.¹

For the buyer, the reclassification lowers the property’s tax basis, because part of what looked like purchase price is now interest expense. A lower basis means less depreciation on an investment property and a larger taxable gain when the buyer eventually sells.¹

Buyers Can Usually Deduct the Interest

The interest the buyer pays, or is deemed to have paid, may be deductible as home mortgage interest if the buyer itemizes and the contract meets the IRS requirements for secured debt. The contract has to make the property security for the debt, allow the property to satisfy the debt in case of default, and be recorded or otherwise perfected under state or local law. When those conditions hold, the buyer reports the interest on Schedule A of Form 1040, using line 8b when there’s no Form 1098.⁷ For debt originating after December 15, 2017, the deduction is limited to interest on up to $750,000 in acquisition debt ($375,000 if married filing separately).

How the Seller Reports the Interest

The seller reports interest received from a contract for deed on Schedule B of Form 1040 and lists the buyer’s name, address, and Social Security number. Each side has to share its taxpayer identification number with the other, and failing to do so carries a $50 penalty per failure.⁸

A seller who finances properties as part of a trade or business has one more step: receiving $600 or more in mortgage interest from an individual buyer in a calendar year triggers a Form 1098 filing with the IRS and a copy to the buyer. A seller carrying a single note on a former personal residence isn’t in a trade or business and doesn’t have to file Form 1098.⁹

Is There a Maximum Rate You Can Charge?

State usury laws would normally set a ceiling, but federal law preempts them for most residential contracts for deed. Under 12 CFR Part 190, state limits on interest rates for federally related residential mortgage loans secured by a first lien don’t apply to loans made after March 31, 1980, and the regulation includes land contracts in its definition of qualifying loans.¹⁰

States were given the option to reject that preemption by passing their own legislation, and a handful did. In those states, the state usury ceiling still applies on top of the AFR floor. Even where federal preemption holds, a very high rate can be challenged as unconscionable, and courts tend to look skeptically at default interest provisions that more than double the base contract rate. In practice, the workable range for a contract-for-deed rate sits between the current AFR and what the market will bear for a comparable seller-financed deal.

Putting the Rate Into the Contract

The contract should state the total purchase price, the down payment, the loan term, and the interest rate. The rate needs to be at or above the AFR for the month you sign, and it’s worth naming which month’s AFR you used. Attach an amortization schedule that splits each payment into principal and interest; both sides will use it at tax time.

Exchange taxpayer identification numbers and note the exchange in the contract. The buyer needs the seller’s TIN to claim the mortgage interest deduction, and the seller needs the buyer’s TIN to report interest on Schedule B. Recording the contract with the county recorder’s office protects the buyer’s interest in the property and satisfies one of the IRS conditions for deducting the interest.⁷

1
Internal Revenue Service. Publication 537 (2025), Installment Sales
2
Internal Revenue Service. Revenue Ruling 2026-7
3
Internal Revenue Service. Applicable Federal Rates
4
Office of the Law Revision Counsel. 26 U.S.C. 1274A
5
Office of the Law Revision Counsel. 26 U.S.C. 483
6
Internal Revenue Service. Gifts and Inheritances
7
Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction
8
Internal Revenue Service. Instructions for Schedule B (Form 1040)
9
Internal Revenue Service. Instructions for Form 1098 (Rev. December 2026)
10
eCFR. Part 190 – Preemption of State Usury Laws