Imputed Interest and the AFR

Imputed Interest and the AFR

What sellers miss on installment notes --- §1274, §483, and the test rate that quietly rewrites a deal

May 6, 2026

A surprising number of installment sales arrive on my desk with the same defect. The headline price is right, the down-payment is right, the amortization schedule looks reasonable, and somewhere on page nine of the note the parties have either left the interest rate blank or set it at a number that, on closer inspection, was picked because it sounded fair rather than because it was checked against anything. The IRS will check it later, and when it does, the consequence is not a polite letter --- it is a quiet rewrite of the deal's tax math.

The rule that does the rewriting is the imputed-interest regime under Internal Revenue Code §1274 and §483 [1][2]. These are not glamorous provisions. Nobody markets a "1274 strategy." But for a seller who is taking back a note for any meaningful portion of a sale price, the test rate that lives inside §1274 and §483 governs how the buyer's payments will be split between principal and interest --- regardless of what the contract says. Get it wrong, and capital gain that should have been taxed at long-term rates instead gets recharacterized as ordinary interest income. The total dollars to the seller don't move, but the after-tax dollars do.

This piece walks through the imputed-interest rules from the seller's perspective: the test rate, where the AFR comes from each month, where the §1274A 9 percent cap fits in, the special 6 percent cap for related-party land sales under §483(e), and how the imputed-interest rules interact with the §453A interest charge that I covered in the prior memo on installment sales [3]. The example throughout is a seller-financed business or real-estate sale ranging from $250,000 to several million dollars.

For most of the twentieth century, Congress was content to tax interest as interest and capital gain as capital gain, and to leave it to the parties to label their own deals. That worked badly. By the 1960s, deferred-payment sales had become a popular way to convert what was economically interest into what was contractually principal. A seller could hand a buyer a five-year note bearing zero stated interest at a price that already included the time-value charge inside the purchase price, and report the entire payment stream as capital gain. The Treasury looked at the resulting revenue loss and concluded that a long-term loan with no interest is not really a loan with no interest --- it is a loan with hidden interest, plus a relabeled cover.

Congress's first response was §483, enacted in the Revenue Act of 1964 (Public Law 88-272) [4]. Section 483 reaches deferred-payment sales of property and recharacterizes part of each payment as "unstated interest" when the contract does not provide for adequate stated interest [2]. Twenty years later, in the Deficit Reduction Act of 1984 (Public Law 98-369), Congress added the more comprehensive original-issue-discount framework of §1274, which applies the OID rules of §§1272-73 to debt instruments issued for property whenever any payment is due more than six months after the sale [1][5]. Section 1274 takes priority over §483; where §1274 applies, the OID rules govern, and §483 fills in the gaps for shorter-term deferred-payment sales that do not trigger §1274 [1][2].

The intent is the same in both regimes: if the seller is going to be paid over time, the IRS wants the interest portion of those payments to be at least as high as the rate the federal government itself is paying on debt of comparable maturity. That benchmark is the Applicable Federal Rate.

The AFR is published monthly by the IRS as a Revenue Ruling, and it has three tiers tied to the term of the debt instrument [1][6]. For May 2026, the rates published in Rev. Rul. 2026-9 are 3.82 percent for short-term obligations of three years or less, 4.08 percent for mid-term obligations of more than three but not more than nine years, and 4.83 percent for long-term obligations of more than nine years, each compounded annually [6]. Semiannual, quarterly, and monthly compounding columns sit alongside the annual column in the same table; the difference between them is small but real on a long note. Figure 1 plots the mid-term AFR (the figure that governs most installment notes on small businesses and real estate) over the past six years to give a sense of where the test rate has been.

The mechanics are simple in concept. A debt instrument provides "adequate stated interest" if its stated principal amount is less than or equal to its imputed principal amount, where the imputed principal amount is the sum of the present values of all the payments on the instrument, discounted at the applicable AFR for the term [1][7]. If the stated rate equals or exceeds the AFR, the contract clears the test and the parties' principal/interest split holds. If the stated rate is below the AFR --- including the common case of zero stated interest --- the instrument has unstated interest (under §483) or original issue discount (under §1274), and a portion of what the contract called principal gets recharacterized as interest income to the seller [1][2].

A few practical points. First, the relevant AFR for a binding contract is generally the lowest 3-month rate in the three calendar months ending with the month the contract becomes binding [1]. That gives a small planning window: if rates are falling, waiting can lower the test rate; if rates are rising, locking in a binding contract before month-end can preserve the prior month's lower rate. Second, the AFR-by-term is not a forecast --- it is a snapshot of where Treasury rates were when the contract was made, not a floating index. Third, sale-leasebacks have a special anti-abuse rule under §1274(e): when the transferor or any related person leases back a portion of the property, the discount rate climbs to 110 percent of the AFR, compounded semiannually [1].

Figure 1: Mid-term AFR (annual compounding) for May of each year, 2020-2026, plus April 2026 for reference. The dashed line marks the §483(e) 6 percent cap available on related-party land sales of up to $500,000 in a calendar year.

Figure 3: May 2026 AFR by term tier alongside the §1274A 9 percent cap (qualified debt instrument, principal up to $7,462,600 for 2026 per Rev. Proc. 2025-32) and the §483(e) 6 percent cap on related-party land sales.

Inside the imputed-interest regime there are two important rate caps that work in the seller's favor and that often go unused because nobody at the closing table flagged them.

The first is the §1274A 9 percent cap [8]. For a "qualified debt instrument" --- broadly, a debt instrument issued for the sale of property where the stated principal amount does not exceed an inflation-adjusted threshold --- the test rate cannot exceed 9 percent, compounded semiannually [8]. The 2026 threshold is $7,462,600, set in Rev. Proc. 2025-32 [9]. In today's rate environment the cap doesn't bite, because the long-term AFR is well below 9 percent. But this cap was the reason so many seller-financed transactions in the 1980s and 1990s could be priced sensibly when AFRs ran double-digits. The cap remains on the books and matters again any time long-term rates climb back into that zone.

The second cap is more useful right now. Under §483(e), for sales of land between related family members --- spouses, ancestors, lineal descendants, brothers, sisters, and certain other family members under §267(c)(4) --- the test rate is capped at 6 percent, compounded semiannually [2][10]. The cap applies to the first $500,000 of aggregate sales price between the same two persons in any calendar year [2][10]. Above $500,000 in the same year, the standard AFR test applies to the excess. The §483(e) cap is a meaningful planning lever when, for example, parents are selling raw land to a child on a long-term note: even when the long-term AFR is 4.83 percent, the related-party rule lets the parties contract for unstated-interest exposure capped at 6 percent rather than facing whatever AFR the future has in store.

A few small-transaction exemptions also exist under §1274(c)(3): sales of farms by individuals where the total payments do not exceed $1,000,000, sales of a principal residence under §121, any sale where the total of the payments due under all instruments and other consideration cannot exceed $250,000, sales involving §1235 patent assignments with contingent payments, and publicly traded debt covered by §1273(b)(3) [1][5]. For practical purposes, the most commonly relevant of these is the $250,000 small-transaction floor, which keeps the OID rules out of routine private deals.

The simplest way to see why this matters is to do the arithmetic. Picture a seller-financed deal: the seller takes a $3.0 million promissory note from the buyer, payable in seven equal annual installments, in exchange for property whose tax basis is small enough that nearly all of the gain is long-term capital gain. (The same logic applies for any installment sale of capital-gain property; I am using $3.0 million because it sits inside the $7.46 million qualified-debt-instrument range and inside the typical small-business sale band.)

Figure 2 compares three versions of that note side by side. In the first, the parties wrote the note with zero stated interest and seven equal annual principal payments of about $428,571 --- a not-uncommon mistake. In the second, the note carries a 2 percent stated rate on a level amortization schedule. In the third, the note carries the May 2026 mid-term AFR of 4.08 percent on a level amortization schedule [6]. In each case, the §1274 test calculates the imputed principal amount by discounting all seven annual payments at 4.08 percent, and treats the difference between the stated principal and the imputed principal as additional unstated interest. At zero stated interest, roughly $435,000 of what the contract calls "principal" is actually OID --- ordinary interest income to the seller as it accrues, rather than long-term capital gain when the principal is paid. At a 2 percent stated rate, the recharacterized amount falls to roughly $226,000. At the AFR, the test is met and there is no recharacterization.

The dollar consequence depends on the seller's bracket. For a seller in the top federal bracket whose long-term capital gains otherwise face the 20 percent rate plus 3.8 percent NIIT (a combined 23.8 percent rate), and whose ordinary income otherwise faces the 37 percent top rate plus the 3.8 percent NIIT on investment income (a combined 40.8 percent rate where the NIIT applies), every dollar that gets recharacterized as interest costs the seller roughly an additional 17 percentage points of federal tax [17][18]. On the zero-stated-interest version of the $3.0 million note, that works out to roughly $74,000 of unnecessary federal tax over the life of the note --- entirely from labeling. The state-tax overlay can add several more percentage points depending on the seller's residence.

The buyer, meanwhile, generally gets the offsetting interest deduction (subject to §163 limitations, and with a noted exception: where the buyer holds the property for personal use, the unstated-interest and OID deductions are not available to the buyer per IRS Publication 537) [11]. So the recharacterization is, broadly, a wash to the federal fisc --- but it is decidedly not a wash to the seller. Brackets differ between buyer and seller. Itemizer-versus-non-itemizer status differs. Investment-interest limitation regimes apply differently. The seller bears the recharacterization cost; the buyer often does not capture the offsetting benefit in full.

Figure 2: Imputed-principal recharacterization on a $3.0 million, 7-year installment note at three stated rates. The May 2026 mid-term AFR of 4.08 percent is the test rate; below it, the difference between stated principal and imputed principal becomes ordinary interest income to the seller.

For sellers of larger businesses, the imputed-interest rules sit alongside the §453A interest charge on deferred tax that I covered in the prior memo [3]. The two rules are independent and stack. The imputed-interest regime determines how each payment is split between principal and interest. The §453A regime then charges interest on the deferred tax attributable to the gain portion of that principal, when the aggregate face amount of nondealer installment obligations outstanding at year-end exceeds $5,000,000 [13][14]. A seller can do the imputed-interest analysis correctly --- charging at least the AFR --- and still owe a §453A interest charge on the deferred tax. They are different problems being solved by different rules.

The practical implication is that a seller financing a large transaction at the AFR has not solved every tax timing question --- they have solved one of two. The interest portion of the buyer's payments is taxed annually at ordinary rates as it accrues. The capital-gain portion of the principal is recognized over time as the principal is paid. And, separately, §453A taps in with an interest charge on the deferred tax above $5 million of face amount [13]. Modeling all three pieces together is the only honest way to project the after-tax economics of an installment sale.

I see five recurring mistakes in seller-financed deals. The first is leaving the interest rate blank because the parties want a "clean" closing and assume the IRS will leave them alone. The second is borrowing an interest rate from a recent unrelated deal --- a number that may have been right last year, but isn't right today, because the AFR moves monthly. Figure 1 makes this concrete: the May mid-term AFR was 0.58 percent in 2020, 4.42 percent in 2024, and 4.08 percent today [6][15]. A rate that cleared the test in 2020 will not clear the test in 2026.

The third mistake is choosing the wrong term tier. A note with a stated maturity of nine years and one month is a long-term obligation; a note maturing in nine years to the day is mid-term [1]. The single month difference can move the test rate by 75 basis points or more. The fourth mistake is forgetting that a balloon payment changes the weighted maturity --- a note with small early payments and a large back-end balloon often falls in a different tier than a level amortization schedule would. The fifth mistake is overlooking compounding frequency. The §483 and §1274 regulations let the parties test using any of the four compounding columns in the AFR table, and choosing among them is a small but real planning question [16].

None of these mistakes are exotic. They show up in routine deals between sophisticated parties when the closing process compresses too far. The fix is mechanical, not clever: pull the current AFR Revenue Ruling, identify the term tier, identify the compounding frequency the parties intend, write the rate into the note, and document the AFR source on the closing statement. That last step --- the documentation --- is the one most often skipped, and it is the one that makes a future IRS examination painless rather than painful.

When a client tells me a sale is being structured with seller financing, the first question I ask --- before goals, before structure --- is what month the contract is expected to become binding and what term the note will run. Those two answers fix the AFR. From there, the analysis moves quickly: confirm the test rate, decide whether the §1274A 9 percent cap or the §483(e) 6 percent related-party cap is in play, model the imputed-interest result against three or four candidate stated rates, and compare the after-tax outcomes. If the deal is large enough to bring §453A into the picture, that calculation runs alongside.

The general principle is that the AFR sets a floor, not a ceiling. The seller can negotiate any stated rate at or above the AFR for the term, and the choice of where to land is partly a tax question --- because interest income is ordinary and capital gain is preferential, every basis point above the AFR moves dollars across that line --- and partly a commercial question, because the buyer is also negotiating against alternative financing. The fair-market rate the buyer would pay a third-party lender is often higher than the AFR, and clients sometimes have negotiating room they did not know existed.

I also do not view the AFR as an academic exercise. I have seen seller-financed deals priced at handshake rates that, once the imputed-interest math was applied, cost the seller mid-five-figures to low-six-figures in unnecessary federal tax. Those numbers are recoverable only at the front end. Once the deal has closed and the IRS has begun its analysis years later, the seller's options narrow to "concede" or "litigate." Neither is appealing.

The imputed-interest regime is the kind of provision that punishes inattention. It does not ask whether the parties meant to underprice the note's interest, and it does not ask whether the omission was inadvertent. It simply applies the test rate, recharacterizes the difference, and sends the seller a corrected tax picture for every year the note is outstanding. The good news is that getting it right is mechanical: the AFR is published monthly, the term tiers are well-defined, the special caps under §1274A and §483(e) are clearly written, and the small-transaction exemptions are clearly written. The bad news is that the deals where the math gets skipped are often the deals where the seller could least afford to lose the basis points.

For any client thinking about seller financing --- whether for a business sale, a real-estate transaction, an intra-family land transfer, or a private debt instrument issued for property --- the work needs to start before the term sheet is signed. That is the moment when the test rate, the term tier, the compounding frequency, and the special caps still have planning room. Once the contract is binding, those parameters are fixed. Our team will continue to coordinate with the M&A attorneys, real-estate attorneys, and CPAs who serve our clients to make sure the imputed-interest math is built into the deal from the start, not retrofitted around it.

This piece is educational. The specifics of any seller-financed transaction --- including which AFR tier applies, whether §1274 or §483 governs, whether a special cap is available, and how the imputed-interest math interacts with the rest of the deal --- require a conversation with your attorney, your CPA, and Perissos before signing.

All my best,

Brandon VanLandingham, CFA, CMT, CFP

Founder / CIO

[1] 26 U.S.C. §1274 (Determination of issue price in the case of certain debt instruments issued for property), https://www.law.cornell.edu/uscode/text/26/1274.

[2] 26 U.S.C. §483 (Interest on certain deferred payments), https://www.law.cornell.edu/uscode/text/26/483.

[3] Perissos Private Wealth Management, "Section 453, the Installment Sale, and the '453 Trust' --- A $25 Million Example" (April 25, 2026).

[4] Public Law 88-272, Revenue Act of 1964 (Feb. 26, 1964), enacting §483 (interest on certain deferred payments) effective for payments made after December 31, 1963.

[5] Public Law 98-369, Deficit Reduction Act of 1984, Division A, Title I, §41(a) (July 18, 1984), enacting §1274 effective for sales or exchanges after December 31, 1984, https://uscode.house.gov/view.xhtml?req=granuleid:USC-prelim-title26-section1274&num=0&edition=prelim.

[6] Rev. Rul. 2026-9 (Applicable Federal Rates for May 2026), Internal Revenue Bulletin 2026-19, https://www.irs.gov/irb/2026-19_IRB.

[7] 26 C.F.R. §1.1274-2 (Issue price of debt instruments to which section 1274 applies), https://www.law.cornell.edu/cfr/text/26/1.1274-2.

[8] 26 U.S.C. §1274A (Special rules for certain transactions where stated principal amount does not exceed $2,800,000), https://www.law.cornell.edu/uscode/text/26/1274A.

[9] Rev. Proc. 2025-32, 2026 inflation-adjusted amounts under §1274A (qualified debt instrument threshold of $7,462,600 for 2026; cash method debt instrument threshold of $5,330,500), https://www.irs.gov/pub/irs-drop/rp-25-32.pdf.

[10] 26 U.S.C. §483(e) (Special rule for certain sales of land between related persons --- 6 percent cap, $500,000 calendar-year limit), https://www.law.cornell.edu/uscode/text/26/483.

[11] IRS Publication 537 (2025), Installment Sales (personal-use exception barring buyer deduction of unstated interest or OID; seller still recognizes the income), https://www.irs.gov/publications/p537.

[12] 26 C.F.R. §1.483-1 (Interest on certain deferred payments), https://www.law.cornell.edu/cfr/text/26/1.483-1.

[13] 26 U.S.C. §453A (Special rules for nondealers; interest charge on deferred tax above $5,000,000 of installment obligations outstanding at year-end), https://www.law.cornell.edu/uscode/text/26/453A.

[14] IRS LB&I Process Unit, Interest on Deferred Tax Liability, https://www.irs.gov/pub/fatca/int_practice_units/interest-on-deferred-tax-liability.pdf.

[15] Historical AFRs (mid-term, annual compounding) for May of each year: May 2020 (0.58%) per Rev. Rul. 2020-11, IRB 2020-19; May 2022 (2.51%) per Rev. Rul. 2022-9, IRB 2022-18; May 2023 (3.57%) per Rev. Rul. 2023-9, IRB 2023-19; May 2024 (4.42%) per Rev. Rul. 2024-9, IRB 2024-19; May 2025 (4.10%) per Rev. Rul. 2025-10, IRB 2025-19; April 2026 (3.82%) per Rev. Rul. 2026-7; May 2026 (4.08%) per Rev. Rul. 2026-9, IRB 2026-19.

[16] 26 C.F.R. §1.483-2 (Unstated interest), https://www.law.cornell.edu/cfr/text/26/1.483-2.

[17] IRS Newsroom, IRS releases tax inflation adjustments for tax year 2026, including amendments from the One, Big, Beautiful Bill (top federal ordinary rate of 37 percent retained for 2026; OBBB §70101 made the 10/12/22/24/32/35/37 percent rate schedule permanent), https://www.irs.gov/newsroom/irs-releases-tax-inflation-adjustments-for-tax-year-2026-including-amendments-from-the-one-big-beautiful-bill.

[18] IRS Topic No. 559, Net Investment Income Tax (3.8 percent NIIT on net investment income above the applicable threshold), https://www.irs.gov/taxtopics/tc559.

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For a complete overview, see our pillar guide: Section 453, the Installment Sale, and the "453 Trust".

How the §453 Installment Method Actually Calculates Gain --- A Worked Example