A purchase money mortgage is a loan the seller of a property extends directly to the buyer to cover part or all of the sale price, secured by the property itself. The buyer takes the deed at closing and makes monthly payments to the seller rather than to a bank. These arrangements come up when a buyer can’t qualify for conventional financing, when the parties want to skip institutional underwriting, or when the seller wants to spread a taxable gain over several years. Federal rules limit how the loan can be structured, and the tax treatment differs sharply from a straight cash sale on both sides.
How the Loan Works
From the outside it looks like an ordinary home sale. The buyer records the deed, moves in, and starts paying monthly. The difference is who holds the note. Instead of a bank wiring funds at closing, the seller accepts payments over time. The buyer signs a promissory note and grants the seller a mortgage or deed of trust, creating a lien on the property that secures the debt.
The defining legal feature is simultaneity: the loan and the property transfer happen as part of one transaction, the debt exists to fund the purchase, and the purchased property itself is the collateral. That connection is what separates a purchase money mortgage from a home equity loan or a later refinance. Courts look for it when deciding lien priority and, in some states, whether the seller can pursue a deficiency after foreclosure.
Documents and Loan Terms
Two documents carry the deal. The promissory note is the buyer’s personal promise to repay, setting out the loan amount, interest rate, payment schedule, term, and events of default. The mortgage or deed of trust is the separate instrument attaching the lien to the property and giving the seller the right to foreclose if payments stop. Both should include a precise legal description pulled from the deed or tax records, not just a street address.
Interest rates on seller-financed loans generally run higher than conventional mortgage rates because the seller is absorbing risk without institutional underwriting. Rates commonly land between 5% and 10%, depending on the buyer’s credit and market conditions. There is a floor. The IRS requires at least the applicable federal rate, or it will recharacterize part of the principal as imputed interest. As of April 2026, the long-term AFR is 4.62% annually and the mid-term AFR is 3.82%.1Internal Revenue Service. Rev. Rul. 2026-7, Applicable Federal Rates Charging less creates tax problems for both sides.
The loan term is negotiable. Whether a balloon payment is permitted depends on how many properties the seller finances in a year, covered below. Other items to settle before signing: late fees, grace periods, whether the seller escrows for taxes and insurance, and what triggers default beyond a missed payment.
Prepayment Penalties
Federal rules narrow the window for prepayment penalties. A penalty is allowed only if the loan carries a fixed rate, qualifies as a qualified mortgage with stable terms and full amortization, and is not a higher-priced loan. Even then, no penalty can apply after the third year. In years one and two, the cap is 2% of the outstanding balance; in year three, it drops to 1%.2eCFR. 12 CFR 1026.43 – Minimum Standards for Transactions Secured by a Dwelling Most seller-financed loans include no prepayment penalty at all, partly because the loan structure often can’t meet the qualified mortgage conditions that would allow one.
Federal Rules Sellers Must Follow
Dodd-Frank didn’t ban seller financing, but it added conditions most sellers don’t learn about until an attorney raises them. The core question is whether the seller is a “loan originator” under Regulation Z. If yes, the seller needs a federal license, which defeats the point for most homeowners. Two exemptions prevent that outcome, each with its own terms.
The One-Property Exemption
An individual, estate, or trust that finances the sale of only one property in any 12-month period avoids loan originator status if the loan meets several conditions: no negative amortization, a fixed rate or an adjustable rate that doesn’t reset for at least five years, reasonable caps on rate adjustments, and the seller owned the property and did not build the home as a contractor. Under this exemption, balloon payments are permitted, and the seller does not have to verify the buyer’s ability to repay.3eCFR. 12 CFR 1026.36 – Prohibited Acts or Practices and Certain Requirements for Credit Secured by a Dwelling
The Three-Property Exemption
Sellers who finance up to three properties in a 12-month period, including entities like LLCs and corporations, face tighter rules. The loan must be fully amortizing with no balloon. The seller must make a good-faith determination that the buyer has a reasonable ability to repay. The same interest rate structure rules apply: fixed or adjustable with a minimum five-year initial period and reasonable caps.3eCFR. 12 CFR 1026.36 – Prohibited Acts or Practices and Certain Requirements for Credit Secured by a Dwelling
Sellers who finance more than three properties in a year generally have to comply with full loan originator licensing, which makes casual seller financing impractical at that volume. The one-versus-three distinction matters most for the balloon question, since a shorter balloon term is how many sellers plan to get their capital back. That option exists only under the one-property exemption.
The Due-on-Sale Trap
Here is the scenario that surprises sellers: you still owe money on your own mortgage when you sell with owner financing. Nearly every conventional mortgage includes a due-on-sale clause allowing the lender to demand full repayment when the property changes hands. Federal law explicitly authorizes lenders to enforce these clauses, overriding any state law to the contrary.4Office of the Law Revision Counsel. 12 USC 1701j-3 – Preemption of Due-on-Sale Prohibitions
The statute protects certain transfers from triggering the clause, including inheritance, divorce-related transfers, transfers to a spouse or children, and transfers into a trust where the borrower remains a beneficiary.4Office of the Law Revision Counsel. 12 USC 1701j-3 – Preemption of Due-on-Sale Prohibitions A sale to an unrelated third-party buyer is not on the list.
The practical consequence is severe. If the original lender discovers the transfer and calls the loan, the seller must pay off the remaining balance immediately or face foreclosure on that original mortgage. The buyer, who has been paying the seller in good faith, could lose the property through no fault of their own. Some sellers proceed anyway, betting the lender won’t notice. That gamble is exactly why a buyer should confirm the property is free and clear before agreeing to a purchase money mortgage.
Lien Priority
A purchase money mortgage generally enjoys what courts call super-priority, meaning it takes first position in the lien order even against the buyer’s preexisting debts. If the buyer already has an outstanding judgment lien from a prior lawsuit, for instance, the seller’s purchase money mortgage still comes first. The reasoning is that without the seller’s financing the buyer would never have acquired the property, so no other creditor should be able to reach the asset ahead of the person whose credit made the acquisition possible.
This matters most in a default. After property taxes, which always sit at the top of the stack, the purchase money lender is paid before judgment creditors and other lien holders. Recording the mortgage promptly protects that position, since an unrecorded lien can lose priority to a later good-faith purchaser or creditor who records first.
Closing and Recording
Both sides sign the note and the mortgage or deed of trust in front of a notary, and the mortgage is then filed with the county recorder or registrar of deeds. Recording puts the world on notice of the seller’s lien and protects it against later buyers and creditors. Filing fees typically run $50 to $150 depending on the county and document length.
Compared to a bank closing, several institutional fees drop out: no loan origination fee, no underwriting fee, no lender-mandated appraisal. Title insurance is still a sensible expense for both parties, and a title search is important to confirm no existing liens cloud the property. Transfer taxes still apply where the state or county imposes them. Both parties should budget for an attorney to review the documents.
Tax Rules for Sellers
A seller receiving payments over more than one tax year is conducting an installment sale. Rather than reporting the full gain in the year of closing, the seller recognizes only the profit portion of each payment as it comes in. Every payment breaks into three pieces: return of basis, which is not taxed; capital gain; and interest.5Internal Revenue Service. Topic No. 705, Installment Sales
The interest portion is taxed as ordinary income in the year received. The capital gain portion is taxed at long-term capital gains rates if the seller held the property for more than a year. Spreading the gain out can keep the seller in a lower bracket than a lump-sum sale would, which is one of the main financial reasons sellers offer this kind of financing.
Installment sale income is reported on Form 6252 in the year of sale and every year the seller receives payments after.5Internal Revenue Service. Topic No. 705, Installment Sales A seller who prefers to recognize the full gain upfront can elect out of installment treatment by the due date, including extensions, of the return for the year of sale. That election is generally irrevocable. One trap: if the property was a rental and depreciation was claimed, the depreciation recapture must be reported in the year of sale regardless of the installment election.
Minimum Interest and Imputed Income
If the note sets an interest rate below the applicable federal rate, the IRS will treat part of the stated principal as imputed interest, increasing the seller’s ordinary income and reducing the buyer’s basis in the property.5Internal Revenue Service. Topic No. 705, Installment Sales Which AFR applies depends on the loan term: mid-term for loans of three to nine years, long-term for loans over nine years. For April 2026, those rates are 3.82% and 4.62%.1Internal Revenue Service. Rev. Rul. 2026-7, Applicable Federal Rates The AFR is published monthly and shifts, so the rate that matters is the one in effect when the loan is executed.
Tax Rules for Buyers
A buyer can deduct mortgage interest paid on a seller-financed loan the same way they would deduct interest paid to a bank, provided the mortgage counts as secured debt. The IRS defines that as a debt instrument that makes the home security for repayment and is recorded or otherwise perfected under state law.6Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction An unrecorded purchase money mortgage may not qualify. That’s another reason to record promptly.
Because the seller usually does not issue a Form 1098 (individuals receiving mortgage interest outside a trade or business aren’t required to), the buyer reports the deduction on Schedule A, line 8b, and must include the seller’s name, address, and taxpayer identification number.7Internal Revenue Service. Instructions for Form 1098 The seller is required to provide the TIN, and the buyer must provide theirs in return. A Form W-9 handles the exchange. Missing these numbers can trigger a $50 penalty for each omission.6Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction
Sellers who are in the real estate business (a developer financing homes in their own subdivision, for example) do have to issue Form 1098 if they receive $600 or more in mortgage interest during the year.7Internal Revenue Service. Instructions for Form 1098
Default and Foreclosure
When a buyer stops paying, the seller has the same basic remedy any lender has: foreclosure. The process follows state law and comes in two flavors. In a judicial foreclosure, the seller files a lawsuit and a judge determines default before ordering a sale. This can take a year or longer. In a non-judicial foreclosure, the seller works through a trustee named in the deed of trust and bypasses the courts unless the buyer raises a defense. Non-judicial foreclosures often finish within a few months. Not every state allows the non-judicial route, and the choice affects the timeline and the seller’s ability to seek a deficiency. Overall timelines vary from around five months to more than two years by state.
Deficiency Judgments
If the foreclosure sale brings in less than the outstanding loan balance, the shortfall is called a deficiency. Whether the seller can sue the buyer for it depends heavily on state law. Several states prohibit deficiency judgments on purchase money mortgages where the seller was the original lender, on the theory that the seller set the price and chose to extend credit. Other states allow deficiency judgments but cap the amount or require a specific foreclosure method to preserve the right. This protection is one of the distinctive advantages a purchase money mortgage can offer a buyer, and it’s worth checking the state’s rules before signing.
Purchase Money Mortgage vs. Land Contract
Both involve seller financing, but they are not the same thing. In a purchase money mortgage, the buyer receives the deed at closing and the seller holds a lien; the buyer is the legal owner from day one. In a land contract, also called a contract for deed, the seller keeps legal title until the buyer finishes paying the full purchase price. The buyer has possession and an equitable interest but doesn’t own the property outright until the contract is satisfied.
The distinction matters if the deal falls apart. A defaulting buyer under a purchase money mortgage faces formal foreclosure with judicial oversight and statutory timelines. A defaulting buyer under a land contract may face forfeiture, where the seller reclaims the property under the contract terms with fewer procedural protections. Land contracts also sit outside much of the federal regulatory framework that governs mortgages. For a buyer with any negotiating leverage, a purchase money mortgage is usually the stronger structure to ask for.