Section 1274 of the Internal Revenue Code sets the minimum interest rate for debt instruments issued in exchange for property. When a seller takes back a note as part of a property sale and the deal is large enough to fall under the section, the note has to carry interest at least equal to the Applicable Federal Rate (AFR) that the IRS publishes each month. If it does not, the IRS treats part of what the parties called principal as interest instead, which reshuffles the tax bill for both the buyer and the seller.
When Section 1274 Applies to Your Deal
Three conditions have to be true at the same time before Section 1274 reaches a transaction:
- The total of all payments due under the debt instrument, plus any other consideration the seller receives, exceeds $250,000.
- At least some payments on the debt are due more than six months after the sale date.
- Neither the property nor the debt instrument is publicly traded.
The classic fact pattern is a seller-financed sale of a business or commercial real estate where the buyer signs a promissory note. Deals at or under the $250,000 threshold do not escape interest scrutiny; they just move to the simpler rules of Section 483.
Which AFR You Use
The AFR is actually three rates. A short-term rate covers debt instruments with terms of three years or less. A mid-term rate covers terms longer than three years but not longer than nine. A long-term rate covers anything over nine years.1Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property Each is derived from average market yields on Treasury obligations of comparable maturities, so the AFR tracks the bond market. A new revenue ruling publishes the current figures every month; all of them are posted at irs.gov/applicable-federal-rates.2Internal Revenue Service. Applicable Federal Rates (AFRs) Rulings
You are not stuck with the rate for the month the sale closes. Regulations let you use the lowest AFR from a three-month lookback window: the lower of the lowest rate during the three months ending with the first month you had a binding written contract, or the lowest rate during the three months ending with the closing month.3eCFR. 26 CFR 1.1274-4 – Test Rate With no binding written contract, you use the lowest rate from the three months ending with closing. In a rising-rate environment, that window can save real money.
The Adequate Stated Interest Test
Section 1274 tests your deal by discounting all future payments on the note back to the sale date, using the AFR as the discount rate. The result is the imputed principal amount. If the note’s stated principal is equal to or less than the imputed principal amount, you have adequate stated interest, the issue price equals the face value, and nothing changes.
If the stated principal exceeds the imputed principal amount, the note fails the test. Its issue price drops to the imputed principal amount, and the gap between the stated redemption price and that imputed principal amount becomes Original Issue Discount (OID). That OID is interest for tax purposes, no matter what the contract calls it.
Consider a $1 million commercial building sold on a 10-year note at 1% stated interest when the long-term AFR is well above that. Without Section 1274, the seller would report most of the $1 million as capital gain at preferential rates while the buyer deducted almost no interest. Section 1274 collapses the game: much of what looked like principal is reclassified as interest income to the seller and interest expense to the buyer.
How OID Accrues After You Fail the Test
OID does not spread in equal slices. Both parties use the constant yield method, which front-loads more OID into the early years. Each period, you multiply the note’s adjusted issue price (original issue price plus all OID already accrued) by the yield to maturity, then subtract any cash interest actually paid. What’s left is the OID for that period, which then gets added to the adjusted issue price for the next calculation.
For the lender, each year’s OID accrual is taxable as ordinary interest income even without a cash payment. For the borrower, the same amount is generally deductible as interest expense if the interest would otherwise qualify. Both parties report OID annually regardless of their usual accounting method. Running that calculation every year until the note is paid off is where seller-financed deals get expensive to administer.
Reporting the OID Each Year
If OID includible in gross income for the year is $10 or more, the lender must file Form 1099-OID with the IRS and give a copy to the borrower.4Internal Revenue Service. About Form 1099-OID, Original Issue Discount Paper filings are due by the end of February; electronic filings are due by March 31.
The borrower reports the OID amount on their return and, if applicable, claims the matching deduction. Because the adjusted issue price changes every period and the figures compound, clean records from year one matter. Reconstructing missed OID accruals during an audit is painful and costly.
Exemptions From Section 1274
Several categories of transactions are carved out entirely:
- Debt instruments arising from the sale of an individual’s principal residence.1Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
- Sales of property where substantially all of the seller’s use was personal rather than business or investment, measured as of the date the debt instrument is issued.5Legal Information Institute. 26 USC 1275(b)(3) – Definition of Personal Use Property
- Sales where total payments and other consideration do not exceed $250,000, which fall under Section 483 instead.
- Sales of farms by individuals, qualifying small business corporations, or similar-sized partnerships where the total sale price does not exceed $1,000,000.
The residence and personal use exemptions do most of the work in practice. A parent seller-financing a home sale to a child does not have to worry about the imputed interest rules if it was their principal residence. Rental and investment property does not qualify.
Rate Caps That Reduce the Hit
The 9% Cap on Qualified Debt Instruments
Section 1274A caps the discount rate for the adequate stated interest test at 9%, compounded semiannually, for “qualified debt instruments.”6Office of the Law Revision Counsel. 26 USC 1274A – Special Rules for Certain Transactions Where Stated Principal Amount Does Not Exceed $2,800,000 A qualified debt instrument has a stated principal amount at or below a $2,800,000 base figure that adjusts annually for inflation. The cap only matters when AFRs push above 9%; below that, the AFR controls.
Section 1274A also allows a cash method election for smaller deals. When the stated principal does not exceed a $2,000,000 base figure (also inflation-adjusted), the borrower and lender can jointly elect out of OID accrual and report interest on a cash basis. The lender cannot already be on the accrual method and cannot be a dealer in the property sold. Check the current IRS revenue procedure for the inflation-adjusted thresholds in the year of your transaction.
The 6% Cap on Family Land Sales
When an individual sells land to a family member, Section 483(e) caps the test rate at 6%, compounded semiannually. The cap applies only if total sales between the same two individuals in a calendar year stay at or below $500,000.7Office of the Law Revision Counsel. 26 USC 483 – Interest on Certain Deferred Payments It covers land only, not buildings or other property, and family is defined by the related-party rules in Section 267(c)(4).
How Section 1274 Fits With Sections 483 and 7872
Three Code sections police below-market interest, and they do not overlap. Section 483 handles deferred-payment property sales at or below $250,000 or where Section 1274 otherwise does not apply, treating the shortfall as “unstated interest” rather than OID.7Office of the Law Revision Counsel. 26 USC 483 – Interest on Certain Deferred Payments
Section 7872 covers below-market loans that are not tied to a property sale, such as interest-free family loans or employer-employee loans. By its own terms, Section 7872 does not apply to any transaction governed by Section 483 or Section 1274.8Office of the Law Revision Counsel. 26 U.S. Code 7872 – Treatment of Loans With Below-Market Interest Rates If you are financing a property sale, you are in Section 1274 or Section 483 territory. If you are making a loan without a property exchange, Section 7872 is the one to read.
Penalties for Getting It Wrong
Mishandling imputed interest exposes both parties to standard IRS penalties. The accuracy-related penalty under Section 6662 is 20% of the underpayment attributable to negligence, disregard of rules, or a substantial understatement of income, and it doubles to 40% for a gross valuation misstatement.9eCFR. 26 CFR 1.6662-2 – Accuracy-Related Penalty
Failing to file a return reporting the income triggers a late-filing penalty of 5% of the unpaid tax per month, capped at 25%. A separate 0.5% per month late-payment penalty applies to tax shown on a return but not paid by the due date, also capped at 25%. Interest runs on top of all of it. The lender also faces information return penalties for a late or missing Form 1099-OID. None of these penalties require intent; not knowing about the imputed interest rules is enough to incur them.