Imputed Interest

In depth

When a seller-financed deal states an interest rate below the Applicable Federal Rate (AFR), the IRS imputes interest at the AFR and recharacterizes part of the principal as interest. This increases the seller's ordinary income and reduces capital gain. Misconception: imputed interest is not just a paperwork issue; it can substantially shift tax liability and surprise sellers who tried to favor a buyer with a low rate. Practically, sellers should always state at least the AFR for the term and compounding period, published monthly by the IRS in Revenue Rulings. For owner-occupied buyers, the OID rules under Section 1274 apply; for some smaller deals, Section 483 simpler rules apply. Form 6252 calculations rely on accurate interest treatment. Always confer with a tax professional.