A forgivable seller note is a promissory note the buyer gives the seller as part of the purchase price, where some or all of the balance is canceled if the buyer meets conditions set out in the note after closing. It looks like an ordinary seller-financed loan on the surface — stated principal, interest rate, payment schedule — but a forgiveness clause layered on top ties debt cancellation to specific benchmarks. Hit them, and the corresponding portion of the debt disappears. Miss them, and the balance stays payable on the original schedule. These notes show up in business acquisitions and real estate deals where the buyer cannot cover the full price at closing and the seller is willing to share risk on the buyer’s future performance.
How the Note Is Structured
The base document is a standard promissory note. Principal equals whatever slice of the purchase price the parties finance rather than pay at closing. Repayment usually runs as monthly or quarterly installments of principal and interest, amortizing like any other loan, until a forgiveness trigger cancels part or all of the remaining balance.
What sets these notes apart is the forgiveness language sitting on top of the repayment terms. The note identifies conditions — revenue targets, employee retention, staying in business for a set number of years — and cancels debt when those conditions are satisfied. The forgiveness provisions typically live in a separate conditions section, making clear that the base obligation is to repay and that the cancellation is conditional. Until a trigger is met, the note is a binding debtor-creditor agreement enforceable on its original terms.
The AFR Floor on Interest
The interest rate is not purely a negotiation. The IRS publishes Applicable Federal Rates each month, and if the note charges less than the AFR, the IRS will recharacterize part of the principal payments as imputed interest under 26 U.S.C. §1274.1Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property Both parties end up with tax consequences from interest they never actually exchanged.
As of mid-2026, the AFR for annual compounding sits at 3.85% for short-term instruments (up to three years), 4.13% for mid-term (three to nine years), and 4.87% for long-term (over nine years).2Internal Revenue Service. Revenue Ruling 2026-11 – Applicable Federal Rates for June 2026 The rate that matters is the one published for the month the note is issued, and the IRS posts updated rates on its AFR page.3Internal Revenue Service. Applicable Federal Rates Most seller notes charge well above the AFR to compensate for the seller’s risk, but setting the rate at or above the AFR is the baseline.
What Triggers Forgiveness
Cancellation happens when the buyer meets benchmarks written into the note. Triggers generally fall into three categories, and a single note can combine more than one.
- Time-based triggers cancel the debt in annual increments, often 20% of the principal each year, as long as the buyer remains in operation or retains ownership. The seller is rewarding continuity.
- Revenue-based triggers, sometimes called earn-outs, tie forgiveness to gross revenue, net income, or EBITDA targets. Hitting the number cancels a corresponding portion of the debt. Missing it keeps the obligation alive.
- Performance-based triggers cover non-financial benchmarks: customer retention, renewal of key contracts, license maintenance, or regulatory inspections. They come up most in professional services and healthcare deals where relationships and compliance drive value.
Triggers have to be defined with precision. Not “the business does well,” but “gross revenue exceeds $2 million in the fiscal year ending December 31, 2027, as reflected in audited financial statements.” Vague language invites disputes. The note should also state how the buyer proves a milestone was met, whether through tax returns, audited financials, or third-party verification.
How Forgiveness Is Taxed for the Buyer
Cancelled debt is generally income. Under 26 U.S.C. §61(a)(11), discharge of indebtedness is included in gross income.4Office of the Law Revision Counsel. 26 USC 61 – Gross Income Defined Without a specific exclusion, a buyer whose $200,000 seller note is partially forgiven would owe federal income tax on the forgiven amount at ordinary rates, up to 37% for taxable income above $640,600 in 2026.5Tax Foundation. 2026 Tax Brackets and Federal Income Tax Rates
The exclusion that makes forgivable seller notes work sits in Section 108(e)(5). When a seller reduces the buyer’s purchase-money debt, the debt that arose from the purchase of the property itself, the reduction is treated as a purchase price adjustment rather than cancellation of debt income.6Office of the Law Revision Counsel. 26 USC 108 – Income from Discharge of Indebtedness The buyer pays no tax on the forgiven amount. Instead, the buyer’s tax basis in the acquired property or business assets drops by the forgiven amount, which flows through to future depreciation deductions and gain on resale.
Section 108(e)(5) applies only when the buyer is solvent and not in bankruptcy at the time of forgiveness, and the debt has to be owed directly to the seller rather than to a third-party lender who bought the note. When the parties document the note with clear language showing the forgiveness is a purchase price adjustment, this treatment is usually straightforward. Getting the documentation right at the outset is where most of the tax planning value lives.
What the Seller Faces
Sellers often focus on the buyer’s tax picture and miss their own. A seller financing part of a sale typically reports gain under the installment method of 26 U.S.C. §453, recognizing income proportionally as payments come in rather than all at once.7Office of the Law Revision Counsel. 26 USC 453 – Installment Method Each payment splits between return of basis, capital gain, and interest income.
Forgiving part of the note effectively reduces the total sale price. The gross profit ratio used to calculate gain on each installment shifts. If the seller has already reported gain on earlier payments based on a higher total contract price, reporting going forward may need to be adjusted. The forgiven principal reduces the seller’s amount realized and can shrink the overall capital gain. The interest the seller would have received on the forgiven balance simply goes away. Because the installment sale rules and the forgiveness interact in ways that depend on timing and amounts, sellers should work through the math before agreeing to forgiveness terms.
Offset Clauses
Buyers negotiating a forgivable seller note often push for an offset clause. An offset provision lets the buyer reduce payments on the note by valid claims against the seller, most commonly indemnification claims for breaches of the representations and warranties in the purchase agreement. Instead of paying the note in full and chasing the seller separately for damages, the buyer deducts the claim directly.
The mechanics matter. A well-drafted offset clause requires the buyer to deliver written notice specifying the nature and dollar amount of the claim, the warranty or representation breached, and the contractual basis for the offset. The offset usually takes tentative effect once notice is given, so payments drop while the claim is being resolved, with final resolution requiring either mutual agreement or a court judgment. Sellers resist broad offset language because it hands the buyer leverage to withhold payments, and the scope of what qualifies for offset is one of the most heavily negotiated provisions in the note.
Default and Unearned Forgiveness
The note should define exactly what counts as default and what happens next. Typical events include missed payments, bankruptcy filings, breach of the purchase agreement’s covenants, and failure to maintain insurance on the collateral. The seller ordinarily has the right to accelerate the entire remaining balance upon default, meaning the buyer owes everything at once rather than continuing on schedule.
Most notes include a cure period of 15 to 30 days after written notice, giving the buyer time to fix the problem before acceleration. If the note is secured by real property, the seller must follow the state’s foreclosure procedures before taking the collateral, which adds months. In a business acquisition, the seller’s remedies are usually limited to suing for the balance and recovering attorney’s fees unless the note is secured by specific business assets.
Acceleration and forgiveness create a tension buyers need to understand. If the buyer defaults in year three of a five-year forgiveness schedule, the seller can typically demand payment of the full remaining balance, including amounts that would have been forgiven in years four and five. Forgiveness triggers are prospective; a default wipes out unearned forgiveness. Whether partial forgiveness already earned survives a subsequent default depends on how the note is drafted, and that is worth pinning down before signing.
Subordination to Bank Financing
When the buyer uses bank financing alongside the seller note, the bank will almost always require the seller note to be subordinated. Subordination means the bank gets paid first from cash flow and from any liquidation proceeds. The seller sits behind the bank.
Subordination agreements often go further than payment priority. Standstill provisions can prevent the seller from accelerating the note, exercising default remedies, or collecting payments at all while the senior debt is outstanding and in default. Some agreements block any payments to the seller until the bank loan is repaid in full. For a forgivable seller note, that can mean the forgiveness triggers run their course before the seller receives a dollar, which is fine if the business performs well and the debt is canceled anyway, but leaves the seller with no collateral recovery if the bank sweeps everything first.
Residential Real Estate and Dodd-Frank
If the note involves residential real estate, federal consumer lending rules apply. Dodd-Frank and the CFPB’s Regulation Z classify most people who offer or negotiate loan terms as “loan originators,” triggering licensing, disclosure, and ability-to-repay requirements. Sellers financing a home sale can avoid those requirements only if they fit within one of two exemptions.
The one-property exemption covers a natural person, estate, or trust that finances the sale of only one property in any 12-month period, as long as the financing does not create negative amortization and uses either a fixed rate or an adjustable rate that does not reset for at least five years with reasonable caps.8eCFR. 12 CFR 1026.36 – Prohibited Acts or Practices and Certain Requirements for Credit Secured by a Dwelling The seller must own the property and cannot have built the home as a contractor. Balloon payments are allowed, and ability-to-repay verification is not required.
The three-property exemption covers up to three properties in a 12-month period and reaches entities, not just individuals, but the loan must be fully amortizing with no balloon payment, and the seller must make a good-faith determination that the buyer can afford to repay.8eCFR. 12 CFR 1026.36 – Prohibited Acts or Practices and Certain Requirements for Credit Secured by a Dwelling Adjustable rates under both exemptions must be pegged to a widely available index like SOFR. Sellers who finance four or more properties in a year are treated as loan originators and must comply with the full federal lending regime. Business acquisitions are outside these rules, because Dodd-Frank’s loan originator provisions apply only to credit secured by a dwelling.9Office of the Law Revision Counsel. 15 USC 1602 – Definitions and Rules of Construction
Drafting and Recording
The note needs the full legal names and addresses of both parties, the principal amount, the interest rate (at or above the AFR for the month of issuance), the payment schedule, late fee terms, and the complete forgiveness language. Late fees on seller-financed notes commonly run around 5% of the missed payment, though the enforceable range depends on state penalty and usury laws. Both parties sign the note before a notary. The seller holds the original; the buyer keeps a certified copy.
For real property transactions, the note is usually secured by a mortgage or deed of trust, and that security instrument has to be recorded with the county clerk or recorder’s office to create a public lien. Recording fees vary by jurisdiction, and some states impose mortgage recording taxes calculated as a percentage of the loan amount, which can add meaningfully to closing costs on larger deals. Once the recorder stamps and returns a copy, the seller’s security interest is a matter of public record, protecting the seller’s position against later creditors and any future sale of the property.