You don’t have to charge interest on a contract for deed, but the IRS will act as though you did. If the rate stated in the contract falls below the Applicable Federal Rate (AFR) for the month you sign, the IRS splits every payment into principal and imputed interest on its own, and taxes both sides on that reconstructed version of the deal. For most residential contracts for deed, the required rate is the long-term AFR, capped at 9 percent compounded semiannually.
Why the IRS Sets a Floor
A contract for deed is a seller-financed sale. The buyer pays the seller directly over time, and the seller keeps legal title until the balance is paid. Because the seller is functionally a lender, the IRS treats the arrangement like a loan and expects interest to be part of it.
The reason is a tax one. Without a minimum rate, a seller could roll what should be interest income into the purchase price and pay capital gains rates on the whole amount instead of ordinary income rates on the interest portion. Sections 1274 and 483 of the Internal Revenue Code close that door by recharacterizing part of the stated principal as interest whenever the contract’s rate is too low. The IRS calls the result “unstated interest” or “original issue discount” depending on which section applies, and the effect is the same either way: each payment gets carved into a principal piece and an interest piece whether the contract does the carving or not.1Internal Revenue Service. Publication 537 (2025), Installment Sales
What the Minimum Rate Is
The floor is the AFR in effect during the month you sign the contract. The IRS publishes AFRs monthly as revenue rulings, in three tiers by contract length:
- Short-term: contracts of three years or less
- Mid-term: contracts longer than three years but not more than nine
- Long-term: contracts longer than nine years
Most contracts for deed run longer than nine years, so the long-term AFR is usually the one that matters. As a reference point, the April 2026 AFRs for annual compounding were 3.59 percent short-term, 3.82 percent mid-term, and 4.62 percent long-term.2Internal Revenue Service. Revenue Ruling 2026-7 The IRS keeps a page linking every monthly ruling.3Internal Revenue Service. Applicable Federal Rates
Setting the rate at or above the AFR for the month of signing satisfies the requirement for the life of the contract. If AFRs climb later, your contract is still fine.
The 9 Percent Cap
The test rate for adequate stated interest can’t exceed 9 percent compounded semiannually for what the IRS calls a “qualified debt instrument.” A debt instrument qualifies if the stated principal doesn’t exceed a threshold that started at $2,800,000 and adjusts annually for inflation.4Office of the Law Revision Counsel. 26 U.S.C. 1274A – Special Rules for Certain Transactions Where Stated Principal Amount Does Not Exceed $2,800,000 The vast majority of contract-for-deed sales sit well below that ceiling.
In practice the cap only matters in unusual rate environments. When long-term AFRs are below 9 percent, the AFR is your floor and the cap is a nonissue. If long-term AFRs ever climbed above 9 percent, the test rate would still cap out at 9 percent for a qualifying sale.
Family Land Sales Get a Lower Ceiling
Selling land to a family member gets a more generous test rate. Under Section 483(e), the test rate on a sale of land between family members can’t exceed 6 percent compounded semiannually, regardless of where the AFR sits.5Office of the Law Revision Counsel. 26 U.S.C. 483 – Interest on Certain Deferred Payments A parent selling a parcel to a child can charge 6 percent even in a higher-rate environment.
Two limits apply. The rule covers only land, not improved structures sold separately from the underlying parcel. And the total price of all qualifying sales between the same two family members in a calendar year can’t exceed $500,000. Anything above that reverts to the standard AFR test. Sales involving a nonresident alien don’t qualify at all.
Even at the reduced rate, forgone interest on a family sale can create gift tax exposure. The IRS treats a below-market loan between family members as a gift to the extent of the interest not charged, and if the forgone interest exceeds the $19,000 annual gift tax exclusion for 2026, the seller may need to file Form 709.6Internal Revenue Service. Gifts and Inheritances
What Happens If You Charge Too Little
The IRS doesn’t fine you for a low rate. It just recomputes the deal. Every payment gets retroactively split into principal and imputed interest, and both parties absorb the tax consequences of that split.
For the seller, income shifts from capital gains into ordinary income. Total dollars received don’t change, but a portion of what the seller expected to report as gain on the sale is reclassified as interest income, which is taxed at ordinary rates. The IRS also reduces the stated selling price by the amount of imputed interest, which alters the gain calculation on the installment sale itself.1Internal Revenue Service. Publication 537 (2025), Installment Sales
For the buyer, the property’s tax basis drops, because part of what looked like purchase price is now treated as interest expense. Lower basis means less depreciation if the property is held as an investment, and potentially a larger taxable gain when the buyer eventually sells.1Internal Revenue Service. Publication 537 (2025), Installment Sales The imputed interest may itself be deductible as mortgage interest if the buyer itemizes and the contract meets the IRS’s requirements for secured debt, including that the property secures the debt and that the contract is recorded or otherwise perfected under state law.7Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction
Putting the Rate in the Contract
The contract should state the total purchase price, the down payment, the loan term, and the interest rate, and it should identify which month’s AFR the rate is measured against. Attaching an amortization schedule breaks each payment into principal and interest and gives both parties a ready record at tax time.
Both sides also need to exchange taxpayer identification numbers and document the exchange. The buyer needs the seller’s TIN to claim any mortgage interest deduction; the seller needs the buyer’s TIN to report interest income. Failing to furnish a TIN carries a $50 penalty per failure. Recording the contract with the county recorder protects the buyer’s interest in the property and satisfies one of the IRS’s requirements for the mortgage interest deduction.7Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction
How the Seller Reports the Interest
The seller reports all interest received from a contract for deed on Schedule B of Form 1040, and the return must include the buyer’s name, address, and Social Security number.8Internal Revenue Service. Instructions for Schedule B (Form 1040)
Sellers who finance properties in the course of a trade or business have an additional filing. If they receive $600 or more in mortgage interest from an individual buyer during the year, they file Form 1098 with the IRS and send a copy to the buyer. A seller carrying a note on a former personal residence doesn’t have to file Form 1098, because the interest isn’t received in a trade or business.9Internal Revenue Service. Instructions for Form 1098 (Rev. December 2026)
Is There a Maximum Rate?
State usury laws would ordinarily cap the top end, but federal law preempts those caps for most residential contracts for deed. Under 12 CFR Part 190, state interest-rate limits don’t apply to federally related residential mortgage loans secured by a first lien and made after March 31, 1980, and the regulation explicitly includes land contracts.10eCFR. Part 190 – Preemption of State Usury Laws
States were allowed to opt out of that preemption, and a handful did. In an opt-out state, the state ceiling applies on top of the AFR floor. Even where federal preemption holds, courts can still review an unusually high rate on unconscionability grounds, and default interest provisions that more than double the base rate tend to draw the closest scrutiny. In the ordinary case, the workable range sits between the current AFR and whatever a comparable seller-financed deal in the local market will bear.