Is There a Minimum Interest Rate for Owner Financing?

The minimum interest rate for owner financing is set by the IRS through the Applicable Federal Rate (AFR), which is published monthly. You can write any rate you want into the note, but if it falls below the AFR in effect the month the loan closes, the IRS treats the transaction as though you charged the AFR anyway and taxes the seller on interest income that never actually arrived.

For February 2026, the long-term AFR (loans over nine years) sits at 4.70% with annual compounding.¹ Because most seller-carry notes run 15 or 30 years, that’s the number that governs a typical deal. The rate that locks in is the one for the month the loan originates, and it stays fixed for the life of the note no matter what later AFRs do.

Which AFR Tier Applies to Your Note

The AFR comes in three tiers, split at three and nine years under Internal Revenue Code Section 1274(d):²

Short-term, for loans of three years or less: 3.56% annual compounding (February 2026).
Mid-term, for loans over three years through nine years: 3.86%.
Long-term, for loans over nine years: 4.70%.

Match the tier to the loan’s stated term. The IRS publishes updated AFRs as revenue rulings each month,³ so check the current ruling before you finalize documents.

What Happens If You Charge Less Than the AFR

The IRS uses one of three mechanisms to recapture the shortfall, depending on how the deal is structured.

Original Issue Discount Under Section 1274

For most seller-financed property sales with payments running past six months, Section 1274 applies. The IRS recalculates the note’s “issue price” by discounting all future payments back at the AFR. The gap between the face amount and that recalculated price becomes original issue discount, and the seller has to report it as interest income spread over the life of the loan even though no additional cash ever changes hands.² The recognized sale price drops too, which can shift dollars out of the capital-gains column and into ordinary income.

Unstated Interest Under Section 483

For deferred-payment sales that fall outside Section 1274, Section 483 acts as a backstop. It uses 110% of the AFR as the test rate, so the bar is slightly higher. Any shortfall is recharacterized as “unstated interest” and taxed as ordinary income.⁴

Below-Market Loan Rules Under Section 7872

If the arrangement looks less like a standard seller-carry note and more like a gift loan or demand loan, Section 7872 governs. The IRS treats the gap between the AFR and the actual rate as “forgone interest,” deemed transferred from lender to borrower and then transferred back as taxable interest income.⁵ The seller owes tax on interest they never collected, and the same forgone amount can register as a gift on the other side of the ledger.

Exceptions That Let You Go Below the AFR

A few provisions carve out room to charge a lower rate without the recharacterization machinery kicking in.

Family Land Sales: 6% Cap

When an individual sells land to a family member, Section 483(e) caps the test rate at 6% compounded semiannually, regardless of how high the AFR climbs.⁴ The break applies only to land, not improved property, and only between family members as defined in the tax code. It’s a meaningful relief valve for farm and ranch families passing acreage down through generations.

Qualified Debt Instruments: 9% Ceiling

Under Section 1274A, if the note’s stated principal doesn’t exceed $7,462,600 for 2026, the discount rate used to test adequate interest is capped at 9% compounded semiannually.⁶⁷ With today’s AFRs well under 9%, this ceiling doesn’t affect current deals. It matters if rates climb past that threshold.

De Minimis Rules for Small Loans

Section 7872 drops out entirely for gift loans between individuals when the outstanding balance never exceeds $10,000, unless the money is used to buy income-producing assets.⁵ For balances between $10,000 and $100,000, imputed interest is capped at the borrower’s net investment income for the year, and is treated as zero if that income is $1,000 or less. These thresholds rarely help in real estate, where the principal is usually well over $100,000, but they can matter for smaller intra-family loans.

Watch the Gift Tax Angle

On a below-market loan between individuals, the forgone interest counts as a gift from lender to borrower under Section 7872. The gift equals the difference between what would have accrued at the AFR and what the borrower actually pays.⁵

For 2026, the annual gift-tax exclusion is $19,000 per recipient. If the forgone interest stays under that number, no gift-tax return is required. But the arithmetic gets close in a hurry. On a $500,000 note at 1% instead of the 4.70% long-term AFR, annual forgone interest runs roughly $18,500, right at the edge. A zero-interest note on the same balance blows past the exclusion and pulls in a Form 709 filing. The lifetime exclusion of $15,000,000 for 2026 means most people won’t actually owe gift tax,⁸ but the filing obligation and the drawdown against that lifetime figure still matter for estate planning.

State Usury Laws Set the Ceiling

Federal tax law fixes the floor. State usury law fixes the top. Every state caps how much interest a lender can charge, and the caps vary widely: some states hover around 10%, others reach 16% or higher depending on loan type. Rules differ enough by state that you need to check your own jurisdiction before settling on a rate.

Some states exempt seller-financed loans secured by real property from standard usury caps when certain conditions are met, such as arm’s-length negotiation between parties with roughly equal bargaining power. The reasoning is that a homeowner carrying back a note isn’t a professional lender, so the same consumer-protection concerns don’t apply with equal force.

The penalties for going over the cap can be severe. Depending on the state, a court may void the interest entirely, reduce the loan balance by excess interest already paid, or in some jurisdictions render the whole contract unenforceable. These consequences can surface years after closing.

Reporting the Interest You Collect

Once you’ve settled on a rate at or above the AFR, the seller still has reporting duties. On Schedule B of Form 1040, you list any mortgage interest received from a buyer using the property as a personal residence, including the buyer’s name, address, and Social Security number. You also have to share your own SSN with the buyer. Missing information triggers a $50 penalty per occurrence.⁹

Sellers who receive $600 or more in mortgage interest in the course of a trade or business must also file Form 1098 for each qualifying mortgage. A seller who simply financed a former personal residence and isn’t otherwise in the lending business doesn’t need to file Form 1098, though the Schedule B requirements still apply.¹⁰

One boundary worth flagging: setting an adequate interest rate handles the tax side, but federal consumer-lending rules under Dodd-Frank can also apply to seller financing depending on how many properties you finance in a 12-month period and how the loan is structured. Those rules are separate from the AFR question and can pull an occasional seller-financer into loan-originator territory with its own disclosure and ability-to-repay requirements.

1
Internal Revenue Service. Rev. Rul. 2026-3 – Applicable Federal Rates for February 2026
2
Office of the Law Revision Counsel. 26 U.S. Code 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
3
Internal Revenue Service. Applicable Federal Rates
4
Office of the Law Revision Counsel. 26 U.S. Code 483 – Interest on Certain Deferred Payments
5
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
6
Office of the Law Revision Counsel. 26 USC 1274A – Special Rules for Certain Transactions Where Stated Principal Amount Does Not Exceed $2,800,000
7
Internal Revenue Service. Rev. Proc. 2025-32
8
Internal Revenue Service. What’s New – Estate and Gift Tax
9
Internal Revenue Service. Instructions for Schedule B (Form 1040)
10
Internal Revenue Service. Instructions for Form 1098 (Rev. December 2026)