Is There a Minimum Interest Rate for Owner Financing?

Yes. Federal tax law sets an effective minimum interest rate for owner financing through the Applicable Federal Rate (AFR), which the IRS publishes each month. Charge less than the AFR on a seller-carried note and the IRS will tax the transaction as if you had charged at least that rate, generating “phantom” interest income for the seller and, in some structures, gift-tax exposure as well. State usury laws set the ceiling; the AFR sets the floor.

How the AFR Works as a Floor

When a seller carries back a note on a property sale, the IRS treats the note as a debt instrument issued in exchange for property. Under Internal Revenue Code Section 1274, if the stated interest falls below the AFR in effect when the loan is made, the note has “inadequate stated interest” and the IRS recalculates the transaction using the AFR as a discount rate.¹ That recalculation reduces the recognized sale price and creates original issue discount, which the seller reports as interest income over the life of the loan.

The AFR in effect during the month the loan originates is the one that governs, and it stays fixed for the life of that note regardless of later rate movements.² Check the current revenue ruling before finalizing loan documents.

Which AFR Applies to Your Note

Section 1274(d) splits the AFR into three tiers by loan term:¹

Short-term, three years or less: 3.56% annual compounding as of February 2026
Mid-term, over three years through nine: 3.86% annual compounding
Long-term, over nine years: 4.70% annual compounding

Most owner-financed real estate deals run longer than nine years, so the long-term AFR is the one that matters for a typical 15- or 30-year seller-carry.³

What Happens If You Charge Less Than the AFR

The IRS uses one of three mechanisms to capture the shortfall, depending on how the deal is structured.

Original Issue Discount Under Section 1274

For most seller-financed sales with payments stretching beyond six months, Section 1274 applies. The IRS recalculates the “issue price” of the note by discounting all future payments at the AFR. The gap between the face amount and the recalculated price becomes original issue discount, which the seller reports as interest income over the loan’s life even though no extra cash changes hands.¹ The seller also recognizes a lower sale price for capital gains purposes, which can shift income from capital gains rates into ordinary income rates.

Unstated Interest Under Section 483

For deferred-payment sales outside Section 1274’s scope, Section 483 acts as a backstop. It uses 110% of the AFR as its test rate, so the bar is slightly higher. Any shortfall gets recharacterized as “unstated interest” and reported as ordinary income.⁴

Forgone Interest Under Section 7872

When a below-market loan is structured as a gift loan or demand loan rather than a standard seller-carry, Section 7872 governs. The IRS treats the gap between the AFR and the actual rate as “forgone interest,” deemed transferred from lender to borrower and then retransferred back as taxable interest income.⁵ The seller owes income tax on interest never actually received, and the transaction may also trigger gift-tax consequences.

Exceptions That Let You Go Lower

A few provisions loosen the AFR floor for smaller or family transactions.

The 6% Cap for Family Land Sales

When an individual sells land to a family member, Section 483(e) caps the test rate at 6% compounded semiannually, regardless of where the AFR sits.⁴ It applies only to land, not improved property, and only between family members as defined in the tax code. That makes it a genuine break for farm and ranch families passing acreage across generations.

The 9% Cap for Qualified Debt Instruments

Under Section 1274A, if the note’s stated principal doesn’t exceed the inflation-adjusted threshold ($7,462,600 for 2026), the discount rate used to test adequate interest is capped at 9% compounded semiannually.⁶⁷ With current AFRs well under 9%, the cap has no practical effect right now, but it matters if long-term rates spike.

De Minimis Rules for Small Loans

Section 7872 drops out entirely for gift loans between individuals when the total outstanding balance never exceeds $10,000, unless the loan finances income-producing assets.⁵ For balances between $10,000 and $100,000, imputed interest for income-tax purposes can’t exceed the borrower’s net investment income for the year, and if that net investment income is $1,000 or less it’s treated as zero. These thresholds mostly matter for small family loans; typical real estate notes clear $100,000.

Gift Tax Exposure on a Below-Market Note

Forgone interest on a below-market loan between individuals counts as a gift from lender to borrower under Section 7872. The gift equals the difference between what would have accrued at the AFR and what the borrower actually pays.⁵ On a large owner-financed note at a very low rate, the annual forgone interest adds up fast.

The 2026 annual gift tax exclusion is $19,000 per recipient. Stay under that and no gift-tax return is required. But on a $500,000 note charging 1% instead of the 4.70% long-term AFR, forgone interest runs roughly $18,500 a year, right at the line. A zero-interest note on the same principal would clear the exclusion and require filing Form 709. The 2026 lifetime exclusion of $15,000,000 means most people won’t actually owe gift tax, but the filing obligation and estate-planning implications still bite.⁸

State Usury Laws Set the Ceiling

Federal tax law sets the floor. State usury law sets the top. Every state limits how much interest a lender can charge, and the caps vary widely. Some states set maximums around 10%; others allow 16% or more depending on loan type. Check your jurisdiction before settling on a rate.

Some states exempt seller-financed loans secured by real property from standard usury caps when conditions like arm’s-length negotiation are met, on the theory that a homeowner carrying back a note isn’t the same as a professional lender. Where the cap does apply, exceeding it can be expensive. Depending on the state, a court may void the interest entirely, reduce the outstanding balance by excess interest already paid, or award the borrower additional damages. In some jurisdictions a usurious loan is unenforceable as a whole. Getting the maximum wrong can unravel a deal years after closing.

One Federal Rule Beyond the Interest Rate

Setting the rate correctly doesn’t finish the job. Dodd-Frank treats sellers who finance more than three properties in a 12-month period as loan originators subject to the same rules as licensed mortgage lenders, including ability-to-repay analysis and TILA-RESPA disclosures.⁹ Sellers financing one property (that they didn’t build) or up to three properties in a 12-month window can qualify for exemptions, but the loan structure has to meet specific conditions on amortization, rate resets, and, for the three-property exemption, a good-faith ability-to-repay determination. If your deal volume is anywhere near those limits, the exemption rules matter as much as the AFR does.

1
Office of the Law Revision Counsel. 26 U.S. Code 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
2
Internal Revenue Service. Applicable Federal Rates
3
Internal Revenue Service. Rev. Rul. 2026-3 – Applicable Federal Rates for February 2026
4
Office of the Law Revision Counsel. 26 U.S. Code 483 – Interest on Certain Deferred Payments
5
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
6
Office of the Law Revision Counsel. 26 USC 1274A – Special Rules for Certain Transactions Where Stated Principal Amount Does Not Exceed $2,800,000
7
Internal Revenue Service. Rev. Proc. 2025-32
8
Internal Revenue Service. What’s New – Estate and Gift Tax
9
Consumer Financial Protection Bureau. 12 CFR 1026.36 – Prohibited Acts or Practices and Certain Requirements for Credit Secured by a Dwelling