RealTown Words

Interest implied by law. When an installment contract, such as a land contract or a mortgage note, fails to state an interest rate or sets an unreasonably low rate, the IRS imputes, or assigns, interest at a prescribed rate (computed semiannually). The applicable federal rate depends on the term of the note, and is determined by the IRS and published monthly. This rule does not apply to installment sales under $3,000.

Section 483 of the Internal Revenue Code, “Interest on Certain Deferred Payments,” and Sections 1271 through 1274, original issue discount rules, prevent the seller from treating as capital gain the part of the selling price that really represented interest on deferred payments. In effect, they prevent deferred payments from being treated wholly as principal. Before the enactment of these sections, parties to a real estate installment sale frequently would omit interest from the contract and raise the purchase price to reflect this omission.

Buyers may deduct for tax purposes, even though no interest is paid, the imputed interest per annum on the unpaid balances. By reallocating the face amount of the note to part interest and part principal (buyer and seller agreement), the buyer may not only carve out an interest deduction but also reduce the basis of the property acquired.