Carrying the note in real estate means the seller finances the sale directly instead of the buyer getting a mortgage from a bank. The buyer signs a promissory note promising to repay the purchase price to the seller over time, with the property itself as collateral, and makes monthly payments to the seller until the debt is paid off. The same arrangement goes by other names — seller financing, owner financing, or a seller take-back mortgage — but the mechanics are the same. The seller becomes the lender and earns interest on the loan.
How the Deal Is Structured
The buyer and seller negotiate the price, down payment, interest rate, and repayment schedule between themselves, then document the deal with the same legal instruments a bank would use. There are two main structures, and the key difference is who holds the deed while the buyer is still paying.
Under a note and mortgage (or deed of trust), the seller transfers the deed to the buyer at closing. The buyer signs a promissory note and a mortgage or deed of trust that gives the seller a recorded lien on the property. The buyer owns the property immediately, and the seller can foreclose if payments stop.
Under a land contract, sometimes called a contract for deed, the seller keeps the deed until the buyer finishes paying the full purchase price. The buyer takes possession and uses the property, but legal title doesn’t transfer until the final payment. This gives the seller more control and typically gives the buyer weaker legal protections.
The note-and-mortgage structure is more common in most states and more closely mirrors a traditional bank loan. Most of what follows applies to that structure, though the tax and payment guidance largely applies to both.
The Documents That Make It Binding
Two documents do the heavy lifting. The promissory note is the actual “note” in “carrying the note.” It’s the buyer’s written promise to repay a specific amount, and it spells out the principal balance, interest rate, monthly payment, due dates, late fees, and the consequences of default.
The second document ties the debt to the property. Depending on state law, this is either a mortgage or a deed of trust. A mortgage involves two parties. A deed of trust adds a neutral third-party trustee who holds limited title and can conduct a foreclosure sale if the buyer defaults. Either way, the document is recorded at the county recorder’s office, which creates a public record of the seller’s lien and establishes priority over later creditors. Both documents are signed at the same closing where the seller signs over the deed.
When the Seller Still Has a Mortgage on the Property
This is where many seller-financing deals get into trouble. If the seller hasn’t paid off their existing mortgage, selling the property, even through seller financing, can trigger the loan’s due-on-sale clause. Federal law explicitly allows lenders to include and enforce these clauses, which let the lender demand the entire remaining balance as soon as the property changes hands without the lender’s consent.1Office of the Law Revision Counsel. 12 U.S. Code 1701j-3 – Preemption of Due-on-Sale Prohibitions
The law carves out a handful of exceptions, including transfers to a spouse, transfers resulting from a borrower’s death, and transfers into certain trusts. A standard seller-financed sale to an unrelated buyer is not one of them.1Office of the Law Revision Counsel. 12 U.S. Code 1701j-3 – Preemption of Due-on-Sale Prohibitions If the lender discovers the transfer and calls the loan, the seller must pay the full remaining balance immediately or face foreclosure on the original mortgage, which also wipes out the buyer’s interest in the property.
Some sellers try to work around this with a wraparound mortgage. The seller’s existing loan stays in place, and the buyer’s payments to the seller are large enough to cover both the old mortgage payment and the seller’s profit. The seller collects from the buyer, then continues making payments on the original loan. The danger runs in both directions. If the seller pockets the buyer’s payments and stops paying the original lender, or if the lender discovers the arrangement and accelerates the loan, the buyer can lose the property even after paying on time. Any deal where the seller still has an existing mortgage calls for a title search and a clear understanding of the due-on-sale risk before anything gets signed.
Federal Rules the Seller Has to Follow
Seller financing doesn’t escape federal regulation entirely. Under the Dodd-Frank Act, anyone who originates a residential mortgage loan generally needs to comply with federal licensing and ability-to-repay rules. The Consumer Financial Protection Bureau carved out two exemptions specifically for property sellers who aren’t in the lending business.2Consumer Financial Protection Bureau. 12 CFR 1026.36 – Prohibited Acts or Practices and Certain Requirements for Credit Secured by a Dwelling
The one-property exemption applies to a person, estate, or trust that seller-finances only one property in any 12-month period. The loan cannot have negative amortization, but balloon payments are allowed. The interest rate must be fixed or, if adjustable, cannot reset for at least five years.
The three-property exemption applies to any seller, including business entities, who finances three or fewer properties in any 12-month period. The requirements are stricter. The loan must be fully amortizing, with no balloon payment, and the seller must make a good-faith determination that the buyer can reasonably afford the payments.
Both exemptions require that the seller actually owned the property and wasn’t the builder or contractor who constructed the home as a regular business activity. Sellers who exceed these limits without a mortgage originator license face potential enforcement action and loan rescission.
Setting the Interest Rate
The interest rate is negotiable, and that flexibility is one of seller financing’s biggest draws. Buyers who can’t qualify for a bank loan may accept a rate above market in exchange for the access to financing. Sellers often earn a better return than they’d get from putting the sale proceeds in a savings account or bond.
But there’s a floor. The IRS requires that any seller-financed loan charge at least the Applicable Federal Rate (AFR) for the loan’s term. The AFR is set monthly and broken into three tiers based on how long the loan lasts: short-term for loans of three years or less, mid-term for loans between three and nine years, and long-term for loans over nine years.3Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property If the stated interest rate falls below the AFR, the IRS treats the difference as imputed interest. The seller owes tax on interest income they never actually collected, and the shortfall may also count as a taxable gift to the buyer. Current AFR rates are published monthly on the IRS website. For most seller-financed real estate deals, the long-term rate applies because the repayment period usually exceeds nine years.
Balloon Payments and the Refinance Exit
Most seller-financed deals don’t run for 30 years the way a traditional mortgage does. A common structure is a five-to-seven-year term with monthly payments calculated as if the loan were amortized over 20 or 30 years, followed by a balloon payment (a lump sum of the entire remaining balance) at the end of the short term. The monthly payments stay affordable, but the buyer needs to come up with a large payoff when the balloon comes due.
The exit strategy is almost always refinancing into a conventional mortgage before the balloon hits. That works well when the buyer’s credit has improved, the property has appreciated, and interest rates are reasonable. It falls apart when any of those assumptions don’t hold. If the buyer can’t refinance, they either need to pay the balloon in cash, negotiate an extension with the seller, or face default. This is the single biggest risk buyers take on in a seller-financed deal.
Under federal rules, the three-property exemption prohibits balloon payments entirely. Only the one-property exemption permits a balloon. Even then, buyers should negotiate the longest possible term and a written option to extend if refinancing isn’t available at maturity.2Consumer Financial Protection Bureau. 12 CFR 1026.36 – Prohibited Acts or Practices and Certain Requirements for Credit Secured by a Dwelling
Tax Consequences for the Seller
Installment Sale Treatment
When a seller carries the note, the IRS generally treats the transaction as an installment sale under Section 453 of the Internal Revenue Code. Instead of paying capital gains tax on the entire profit in the year of the sale, the seller recognizes gain gradually as principal payments come in over the life of the loan.4Office of the Law Revision Counsel. 26 U.S. Code 453 – Installment Method Each payment is split into three components for tax purposes: return of the original cost basis, which is not taxed; capital gain, taxed at capital gains rates; and interest income, taxed as ordinary income in the year received.
The seller reports installment sale income on IRS Form 6252, both in the year of the sale and in every subsequent year that payments are received.5Internal Revenue Service. About Form 6252, Installment Sale Income The installment method is automatic. A seller who prefers to pay all the tax upfront can opt out by reporting the full gain in the year of sale.
Depreciation Recapture
Sellers who previously claimed depreciation on the property, most commonly investors and landlords, get a less favorable deal on that portion of the gain. The IRS requires depreciation recapture to be reported entirely in the year of the sale, even if the seller is using the installment method for the rest of the gain.6Internal Revenue Service. Topic No. 705, Installment Sales A rental property owner who has taken years of depreciation deductions will owe tax on the recapture amount right away, regardless of how little cash they’ve actually received from the buyer at that point. Sellers of depreciated property need to plan for that upfront tax hit.
Tax Consequences for the Buyer
The buyer can deduct the mortgage interest they pay, just like a buyer with a bank loan, as long as the debt is secured by the property and qualifies as acquisition indebtedness under federal tax law.7Office of the Law Revision Counsel. 26 USC 163 – Interest The buyer must itemize deductions on their federal return to claim this benefit. The standard deduction won’t capture it.
For 2026, the mortgage interest deduction limit reverts to $1,000,000 of acquisition debt ($500,000 if married filing separately), following the expiration of the Tax Cuts and Jobs Act’s temporary $750,000 cap.8Congressional Research Service. Selected Issues in Tax Policy: The Mortgage Interest Deduction For most seller-financed residential deals, the purchase price falls well under this limit.
One administrative wrinkle: sellers who aren’t in the business of lending money are not required to send the buyer a Form 1098 at year’s end.9Internal Revenue Service. Instructions for Form 1098 – Mortgage Interest Statement A homeowner who finances the sale of a single personal residence has no obligation to file that form. The buyer can still claim the deduction using the promissory note, payment records, and amortization schedule as documentation.
What Happens If the Buyer Stops Paying
When the buyer misses payments or violates the terms of the promissory note, the seller can’t simply change the locks. The process starts with a formal written notice of default, giving the buyer a window, usually defined in the security instrument and by state law, to catch up on missed payments and late fees. Most promissory notes specify a cure period of around 30 days.
If the buyer doesn’t cure the default, the seller can begin foreclosure. The process varies by state and depends on which security instrument the parties used. In judicial foreclosure states, the seller files a lawsuit, and the case proceeds through the court system. This is slower and more expensive but gives the buyer more procedural protections, including the right to contest the foreclosure in court. In non-judicial foreclosure states, the third-party trustee named in the deed of trust conducts the foreclosure outside the court system, following a statutory notice-and-sale process. This is faster and cheaper for the seller but still must follow state-specific timelines and notice requirements.
In either scenario, the property is sold at a public auction, and the proceeds pay off the outstanding debt: remaining principal, accrued interest, and the seller’s legal costs. If the sale price exceeds the debt, the surplus goes to the buyer. If it falls short, whether the seller can pursue the buyer for the difference depends on state deficiency judgment laws.
For sellers, carrying the note also means carrying the risk of a lengthy and expensive foreclosure. Building a meaningful down payment into the deal, typically 10% or more, gives the buyer real equity to protect and gives the seller a cushion if the property has to be sold at auction for less than its full value.