We want to use an installment sale under Section 453 with a seller note, but we are worried the interest rate we charge will be recharacterized by the IRS under the original issue discount rules. How do we structure the interest rates on our seller note to comply with the Applicable Federal Rate rules without reducing our cash flow?

Question

Tyler Smith · Accepted Answer

If you offer seller financing with an interest rate below the IRS Applicable Federal Rate, the IRS will apply Section 483 or Section 1274 rules to recharacterize a portion of your principal payments as interest income. This is a painful tax surprise because interest income is taxed at high ordinary income rates, whereas principal payments are taxed at lower capital gains rates. To avoid this recharacterization, your seller note must carry an interest rate that is at least equal to the Applicable Federal Rate in effect during the month the binding contract is signed. To maximize your total cash yield without breaking the buyer monthly cash flow, structure a step up interest rate or a payment in kind toggle. You can set the initial cash interest rate at the exact minimum required by the Applicable Federal Rate to keep their initial payments low, while compounding the remaining market rate interest into the principal balance of the note to be paid at maturity. This payment in kind structure keeps you compliant with Section 453 rules, protects your capital gains treatment on the bulk of the transaction, and defers the tax on the unpaid interest until it is actually received or accrued under your accounting method. Work with your CPA during the drafting phase to run these numbers against current IRS tables, ensuring you capture maximum yield with zero tax penalties.