What Is IRC 1274? Imputed Interest, Exemptions, and Section 1274A

IRC Section 1274 is the tax rule that forces a seller-financed property sale to carry a minimum amount of interest. When a buyer and seller set the interest rate on a deferred-payment note below the IRS benchmark known as the Applicable Federal Rate (AFR), Section 1274 recalculates the note as if it carried adequate interest, and the resulting gap becomes imputed interest that both sides must report. For the seller, that means more ordinary income and less capital gain. For the buyer, it means an interest deduction paired with a lower tax basis in the property.

Why the Rule Exists

Before Section 1274, a private seller could set the stated interest rate at zero, add the missing interest to the purchase price, and convert what should have been ordinary interest income into long-term capital gain. The buyer accepted the higher price because it produced a larger depreciable basis. Both sides came out ahead at the Treasury’s expense.

Section 1274 closes that door. Every qualifying deferred-payment sale must carry adequate stated interest. If it doesn’t, the IRS treats the note as though the missing interest were there, and both parties report the recalculated interest, called Original Issue Discount (OID), over the life of the note. The seller ends up with ordinary income on the interest portion and capital gain only on the true principal. The buyer picks up a matching interest deduction each year and starts with a lower basis in the property.

When Section 1274 Applies

The rule targets sales or exchanges of property where at least one payment falls due more than six months after closing and the note fails the adequate-stated-interest test.¹ A sale paid in full within six months never reaches these rules, regardless of the stated rate.

Both the note and the property must generally be non-publicly traded. If either trades on an established securities market, different OID provisions apply. In practice, Section 1274 covers most seller-financed deals involving commercial real estate, closely held businesses, partnership interests, and similar private assets.

Adequacy is tested by comparing the stated principal amount to the “imputed principal amount,” which is the present value of all future payments on the note discounted at the AFR. If the stated principal is greater, the note doesn’t carry enough interest and Section 1274 takes over.²

A significant modification of an existing note can also pull it back into Section 1274. Under Treasury regulations, if the change is large enough that the modified note is treated as a new instrument exchanged for the old one, it gets retested against the current AFR.³ Changes to the rate, maturity, or principal are the most common triggers.

Exemptions and Carve-Outs

Several categories of transactions sit outside Section 1274 entirely under Section 1274(c)(3):⁴

Total consideration of $250,000 or less. Related transactions are aggregated, so splitting one sale into two smaller contracts doesn’t work.
Sale of a principal residence by an individual, regardless of price or rate.
Sales of a farm by an individual, estate, testamentary trust, or qualifying small business corporation or partnership, where the price cannot exceed $1,000,000.
Sales of personal-use property, such as a personal boat, car, or furniture, that isn’t used in a trade, business, or investment activity.
Publicly traded debt instruments or property, which fall under other OID rules.
Certain land transfers between related persons, which are handled by Section 483(e) up to $500,000 in stated principal.

A separate de minimis rule can spare an otherwise covered transaction. If total OID works out to less than one-quarter of one percent of the stated redemption price at maturity multiplied by the number of complete years to maturity, the OID is treated as zero.⁵ On a $500,000 note maturing in five years, OID under $6,250 (0.25% × $500,000 × 5) is disregarded.

Short-term debt instruments with a fixed maturity of one year or less are also excluded from the annual OID inclusion rules, though other provisions can still apply.⁶

How the Imputed Interest Is Calculated

Everything runs through the AFR. The IRS publishes new rates every month based on average yields on U.S. Treasury obligations.⁷ Three tiers match the term of the note:⁸

Short-term: maturity of three years or less.
Mid-term: more than three years but no more than nine.
Long-term: more than nine years.

For March 2026, the annual AFRs are 3.59% short-term, 3.93% mid-term, and 4.72% long-term.⁹ Taxpayers can use the rate in effect for the month the contract becomes binding or either of the two preceding months.

The Discount Calculation

When the stated rate is below the AFR, the IRS recalculates the note’s issue price by taking the present value of every future payment (both principal and stated interest) discounted at the AFR compounded semiannually.² That present value becomes the note’s issue price for tax purposes. The gap between issue price and face amount is the OID.

Consider a commercial building sold for $1,000,000 with seller financing over seven years at 1% stated interest when the mid-term AFR is 3.93%. Discounting the scheduled payments at 3.93% compounded semiannually produces a present value well below $1,000,000. The difference is OID, and the seller reports a portion of it as ordinary interest income each year even though the buyer is only paying cash interest at 1%.

Constant Yield Method

OID doesn’t get spread in equal chunks. Both sides use the constant yield method, sometimes called economic accrual, which recognizes less interest early and more later. Each year’s OID equals the note’s adjusted issue price multiplied by the yield to maturity, minus any qualified stated interest paid that year. The adjusted issue price grows each year by the accrued OID, so the reported interest rises over time.

Sale-Leasebacks

If the seller finances the sale and then leases the property back from the buyer, the discount rate becomes 110% of the AFR rather than 100%.¹⁰ Sale-leasebacks blend financing with a rental arrangement and create room to shift income between categories, so the higher rate narrows that opening.

Potentially Abusive Situations

For transactions the IRS classifies as potentially abusive, the calculation shifts more sharply. Instead of any AFR-based discount, the issue price is set at the fair market value of the property.¹¹ The statute defines these to include tax shelters and deals involving nonrecourse financing, loan terms exceeding the property’s economic life, or other arrangements flagged in Treasury regulations. Using fair market value eliminates any benefit from inflating the stated price.

Relief for Smaller Deals: Section 1274A

Section 1274A softens the impact for transactions that aren’t large enough to justify full compliance. The thresholds are adjusted annually for inflation.¹²

Capped Discount Rate

For a qualified debt instrument with stated principal of $7,462,600 or less (the 2026 threshold), the discount rate used to test adequacy and calculate OID cannot exceed 9% compounded semiannually, even if the AFR is higher.¹³ The cap only bites when AFRs climb above 9%, but it provides a ceiling in high-rate environments.

Cash Method Election

The more useful break lives at the smaller end. When the stated principal is $5,330,500 or less (the 2026 amount), the buyer and seller can jointly elect to account for interest on the cash basis rather than the accrual basis Section 1274 otherwise requires.¹² The election effectively removes the note from Section 1274, and both sides report interest only when cash is paid or received.¹⁴ The lender cannot use an accrual method of accounting and cannot be a dealer in the type of property sold, and both parties must join in the election.

A small business owner selling a company for $3 million with seller financing can sidestep annual OID accruals through this election, assuming the other conditions are met.

What Section 1274 Doesn’t Cover

Two neighboring statutes handle deals that fall outside Section 1274, and confusing them for it is a common error.

Section 483 covers unstated interest in seller-financed property sales that Section 1274 doesn’t reach, typically because a carve-out applies. When Section 1274 governs a transaction, Section 483 steps aside.¹⁵ The practical difference is timing: Section 483 recharacterizes a piece of each payment as interest when the payment is received, while Section 1274 forces annual OID accrual regardless of cash flow. Related-person land transfers up to $500,000 in stated principal fall specifically under Section 483(e).¹⁶

Section 7872 governs below-market loans, including gift loans between family members and compensation-related loans.¹⁷ A straight cash loan from a parent to a child sits in Section 7872. A sale of property from parent to child on a below-market note sits in Section 1274, because property changed hands for a debt instrument. Picking the wrong statute means reporting the wrong amount in the wrong year.

Reporting, Basis, and the NIIT

Reporting kicks in the moment OID exists on the note, whether or not cash is moving.

The seller reports accrued OID as ordinary interest income each year. If the OID includible in gross income for the year is at least $10, the seller issues Form 1099-OID to the buyer.¹⁸ When the note also carries qualified stated interest (the piece that does meet the AFR), the seller can report both amounts on Form 1099-OID or split them across Form 1099-OID and Form 1099-INT.¹⁹

The buyer claims a corresponding interest deduction for the accrued OID each year, subject to the usual limits on interest deductions (investment interest, passive activity, and the rest). The buyer’s basis in the property equals the note’s issue price after the Section 1274 adjustment, not the stated face amount. A larger imputed interest component means a lower starting basis, which reduces future depreciation and increases gain on a later resale.

The seller’s amount realized shrinks by the same imputed interest amount. Capital gain is computed only on the recalculated principal, not on the face amount of the note. Zero-coupon notes create the sharpest cash-flow problem: the seller owes tax on phantom income each year while no cash arrives until maturity.

Imputed interest also counts as investment income for the 3.8% Net Investment Income Tax. The NIIT applies to individuals with modified adjusted gross income above $200,000 (single) or $250,000 (married filing jointly), and those thresholds are not indexed for inflation.²⁰ A seller financing a $2 million property sale at a low rate could face tens of thousands of dollars in annual imputed interest that carries the extra 3.8% on top of ordinary income tax.

Penalties

Underreporting imputed interest income exposes the seller to the accuracy-related penalty of 20% of the underpayment when the IRS attributes the error to negligence or a substantial understatement of income tax.²¹ An understatement is “substantial” when it exceeds the greater of 10% of the tax due or $5,000. Failure to report income shown on a 1099-OID is a strong indicator of negligence.

The seller who never files the required Form 1099-OID faces separate per-form penalties tied to how late the filing arrives:²²

Filed within 30 days of the deadline: $60 per form.
Filed 31 days late through August 1: $130 per form.
Filed after August 1 or not filed at all: $340 per form.
Intentional disregard: $680 per form.

These penalties apply per form and per year. A seller carrying a five-year note who never files a single 1099-OID could face five separate $340 penalties, on top of the 20% accuracy-related penalty on the unreported income. The dollars are modest against the tax at stake on a large seller-financed deal, but they add up quickly when a seller didn’t realize the reporting obligation existed at all.

1
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
2
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property – Section: Imputed Principal Amount
3
eCFR. 26 CFR 1.1001-3 – Modifications of Debt Instruments
4
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property – Section: Exceptions
5
Office of the Law Revision Counsel. 26 USC 1273 – Determination of Amount of Original Issue Discount
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Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount
7
Internal Revenue Service. Applicable Federal Rates
8
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property – Section: Determination of Applicable Federal Rate
9
Internal Revenue Service. Revenue Ruling 2026-6
10
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property – Section: 110 Percent Rate Where Sale-Leaseback Involved
11
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property – Section: Fair Market Value Rule in Potentially Abusive Situations
12
Internal Revenue Service. Revenue Procedure 2025-32
13
Office of the Law Revision Counsel. 26 USC 1274A – Special Rules for Certain Transactions Where Stated Principal Amount Does Not Exceed 2,800,000
14
Office of the Law Revision Counsel. 26 USC 1274A – Special Rules for Certain Transactions Where Stated Principal Amount Does Not Exceed 2,800,000 – Section: Election to Use Cash Method
15
Office of the Law Revision Counsel. 26 USC 483 – Interest on Certain Deferred Payments
16
Internal Revenue Service. Publication 537 (2025), Installment Sales
17
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
18
Internal Revenue Service. About Form 1099-OID, Original Issue Discount
19
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
20
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
21
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
22
Internal Revenue Service. Information Return Penalties