4.32 Minimum Interest on Seller-Financed Sales
The law requires minimum interest charges for seller-financed sales. If the minimum rate is not charged, the IRS imputes interest at the minimum applicable rate requiring both buyer and seller to treat part of the purchase price as interest even though it is not called interest in the sales contract. Generally, interest at the applicable federal rate (AFR) must be charged; see the chart at the end of this section for minimum required rates. For example, investment property is sold on the installment basis for $100,000 and the parties fail to charge adequate interest. Assume the IRS imputes interest of $5,000. For tax purposes, $95,000 is allocated to the sale of the property and the principal amount of the debt; the balance is imputed interest of $5,000, taxable to the seller and deductible by the buyer if allowed under the rules of Chapter 15.
Two statute classes.
The minimum or imputed interest rules are covered by two Internal Revenue Code statutes: Sections 1274 and 483. Under both, the same minimum interest rates apply but the timing of interest reporting is different, as discussed below.
Section 483 applies to any payment due more than six months after the date of sale under a contract which calls for some or all payments more than one year after the date of sale. If the sales price cannot exceed $3,000, Section 483 does not apply. Transactions within Section 483 are sales or exchanges of: (1) principal residences; (2) any property if total payments, including interest and any other consideration to be received by the seller, cannot exceed $250,000; (3) farms if the total price is $1 million or less; and (4) sales of land between family members to the extent the aggregate sales price of all sales between the same parties in the same year is $500,000 or less.
If the selling price exceeds the respective $250,000, $1 million, or $500,000 amount listed in (2) through (4) above, the sale is subject to Section 1274 reporting rules provided some or all payments are due more than six months after the date of sale. Section 1274 also applies to all other transactions where neither the debt instrument nor the property being sold is publicly traded as long as some payments are deferred more than six months.
Caution
Timing of interest reporting.
One important practical difference between the two statutes covering minimum interest involves the timing of the reporting and deducting of interest.
Under Section 483, a seller and lender use their regular reporting method for imputed interest. For a cash-basis seller, interest is taxed when received; a cash-basis buyer deducts interest when paid if a deduction is allowable. However, if too much interest is allocated to a payment period, the excess interest is treated as prepaid interest, and the deduction is postponed to the year or years interest is earned. Section 483 also describes imputed interest as unstated interest.
Under Section 1274, the interest element is generally reported by both buyer and seller according to the OID accrual rules, even if they otherwise report on the cash basis. Where the seller financing is below an annual threshold ($3,813,800 for 2012 sales), the parties can elect the cash method to report the interest regardless of the OID and accrual rules if: (1) the seller-lender is on a cash-basis method and is not a dealer of the property sold and (2) the seller and buyer jointly elect to use the cash method. The cash-basis election binds any cash-basis successor of the buyer or seller. If the lender transfers his interest to an accrual-basis taxpayer, the election no longer applies; interest is thereafter taxed under the accrual-method rules. The OID rules also do not apply to a cash-basis buyer of personal-use property; here, the cash-basis debtor deducts only payments of interest required by the contract, assuming a deduction is allowed under the home mortgage rules discussed in Chapter 15.
Figuring applicable federal rate (AFR).
There is no imputed interest if the sales contract provides for interest that is at least equal to the AFR. See Table 4-1 below for determining the AFR.
Table 4-1 Minimum Interest Rate for Seller Financing
| Type— | Description— |
| Applicable federal rates | The IRS determines the AFR rates which are published at the beginning of each month in the Internal Revenue Bulletin. There are three AFR rates depending on the length of the contract: Short-term AFR—A term of three years or less. Mid-term AFR—A term of over three years but not over nine years. Long-term AFR—A term of over nine years. The imputed interest rules do not apply if the interest rate provided for in the sales contract is at least the lesser of (1) the lowest AFR in effect during the three-month period ending with the month in which a binding written sales contract is entered into, or (2) the lowest AFR in effect during the three-month period ending with the month of sale. If insufficient interest is charged, the total unstated interest is allocated to payments under an OID computation. |
| 9% safe harbor rate | If seller financing in 2012 is $5,339,300 or less, the minimum required interest is the lower of 9% compounded semiannually and the applicable federal rate (AFR). The amount of seller financing is the stated principal amount under the contract. If the seller-financed amount exceeds $5,339,300, the minimum interest rate is 100% of the AFR. The threshold for the 9% safe harbor is indexed annually for inflation. The 9% safe harbor provides a benefit only if it is less than the AFR, but in recent years the AFR has been much lower than 9%. Thus, until prevailing interest rates substantially increase, charging interest at the AFR will be sufficient to avoid application of the minimum interest rules. IRS regulations allow the parties to use an interest rate lower than the AFR if it is shown that the borrower could obtain a loan on an arm’s-length basis at lower interest. |
| Seller-financed sale-leaseback transactions | Interest equal to 110% of AFR must be charged. |
| Sales of land between family members |
To the extent that the sales price does not exceed $500,000 during a calendar year, the minimum required interest rate is 6%, compounded semiannually. To prevent multiple sales from being used to avoid the $500,000 limit, the $500,000 ceiling applies to all land sales between family members during the same year. To the extent that the $500,000 sales price limit is exceeded, the general 9% or 100% of AFR rules apply. |
Assumptions of loans.
The imputed interest rules of Sections 1274 and 483 do not generally apply to debt instruments assumed as part of a sale or exchange, or if the property is taken subject to the debt, provided that neither the terms of the debt instrument nor the nature of the transactions are changed.
Important:
In planning deferred or installment sales, review Treasury regulations to the Internal Revenue Code Sections 483 and 1274 for further examples and details.