Do You Have to Charge Interest on a Contract for Deed?

A contract for deed is a form of seller financing for purchasing real estate. In this arrangement, a buyer makes regular payments directly to the seller over a specified period. This differs from a traditional mortgage where a bank or other lending institution provides the funds. The seller retains legal ownership of the property until the buyer completes all the agreed-upon payments.

Under the terms of the agreement, the buyer is granted equitable title and the right to occupy and use the property while making payments. This structure can be advantageous for buyers who may not qualify for conventional financing and for sellers seeking a steady income stream.

The IRS Imputed Interest Rule

While parties to a contract for deed can agree on any interest rate, including zero, the Internal Revenue Service (IRS) has specific regulations to consider. The primary concern for the IRS is preventing the mischaracterization of interest income as a capital gain for tax avoidance. Interest income is taxed at ordinary income rates, which are often higher than the rates for long-term capital gains, so the IRS established the “imputed interest” rule.

This rule applies when a contract for deed either states no interest or specifies a rate below the minimum level set by the government. In such cases, the IRS will recharacterize a portion of the buyer’s principal payments as interest. For federal tax purposes, this means the transaction is treated as if the seller received interest payments, even if no cash interest was actually exchanged. The seller must then report this imputed interest as taxable income.

The logic behind this regulation, found in the Internal Revenue Code, is to ensure the economic reality of the transaction is reflected for tax purposes. Which set of rules applies depends on the sale price of the property. Section 483 governs transactions with total payments of $250,000 or less, while Section 1274 applies to larger sales.

Determining the Minimum Interest Rate

To comply with tax law, sellers must charge an interest rate that is at least equal to the Applicable Federal Rate (AFR). The AFR is the minimum rate the IRS considers acceptable for private loans, and it is published monthly to reflect current market conditions. Failing to meet this minimum standard triggers the imputed interest rules, regardless of the terms agreed upon by the buyer and seller.

The IRS establishes three distinct AFRs based on the duration of the loan agreement:

• Short-term rate applies to loans with a term of three years or less.
• Mid-term rate is used for loans over three years but not more than nine years.
• Long-term rate must be used for any contract with a term exceeding nine years.

Sellers must use the AFR that is in effect for the month in which the legally binding contract for deed is signed. These rates can be found directly on the IRS website. Applying the correct rate for both the month of the sale and the specific term of the contract is necessary to avoid unintended tax consequences.

Calculating Tax Consequences of Below Market Interest

When the interest rate in a contract for deed is below the required Applicable Federal Rate (AFR), the IRS uses a concept called Original Issue Discount (OID) to determine the tax implications. OID represents the difference between the loan’s stated redemption price at maturity and its issue price. The issue price is not the face value of the loan but rather its present value, calculated by discounting all future payments using the appropriate AFR.

This calculated OID is treated as a form of interest for tax purposes. Consider a sale of a $200,000 property with a 10-year contract for deed at 0% interest, at a time when the long-term AFR is 4%. The IRS would use the 4% AFR to calculate the present value of the $200,000 in payments, which would be a lower figure, for instance, $164,350. The difference of $35,650 would be classified as OID.

The tax consequences of this OID affect both the seller and the buyer over the life of the loan. The seller is required to report portions of this OID as interest income each year, even though no actual interest payments are received. Conversely, the buyer is permitted to deduct the same amount as interest expense annually, which can lower their taxable income.

Exceptions to the Imputed Interest Rule

The imputed interest rules do not apply to every transaction, as the Internal Revenue Code provides specific exceptions. These are designed for situations where the potential for significant tax avoidance is considered low.

One of the most common exceptions is for sales of property for $3,000 or less. If the total sales price of the property under the contract for deed does not exceed this amount, the imputed interest rules are not triggered. This allows for small, informal transactions to proceed without complex tax calculations.