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How to Structure Seller Financing: Terms, Down Payment, Balloon

By Hans Goldstein · Updated 2026-09-27

To structure seller financing, you set six terms: the down payment, the interest rate, the amortization and balloon, the security, the prepayment terms and who services the loan. A common starting point is 20% down, a rate above the applicable federal rate, a 25 to 30 year amortization with a 5 or 7 year balloon, a first-position deed of trust with tax and insurance requirements, and a professional servicer. Each choice also sets your tax timing: the down payment and any loan payoff are taxed in year one, and the balloon or an early payoff pulls the rest of the gain into the year it arrives.

For the basics of how seller financing works, start with our seller financing guide. This article is about getting the terms right.

Start with the down payment

The down payment does two jobs. It gives the buyer something to lose, and it gives you cash at closing.

Typical range. Many seller-financed deals use 10% to 30% down, with 20% a common anchor. Nothing in the tax law sets a minimum. What matters is whether the buyer's equity is big enough that walking away would hurt, and whether the property would sell for enough to cover your balance if you had to take it back.

How to size it. Work backward from three numbers:

1. Your existing loan payoff. If you have a mortgage, it almost certainly has a due-on-sale clause the lender can enforce (12 U.S.C. §1701j-3(b)), so it usually has to be paid at closing. The down payment must at least cover it, plus closing costs. See due-on-sale clause.
2. The tax you will owe for the year of sale. See below.
3. A cushion against a price drop. If values fell 15% and you had to foreclose, would the property still cover your note plus costs?

Why the tax on the down payment lands in year one. On the installment method, each dollar of principal you receive carries the same share of gain, the gross profit ratio (§453(c)). The down payment is principal received at closing, so its share of gain is taxed in the year of sale. Cash from closing that goes to pay off your own loan is still money you received; the buyer paid it on your behalf. Only a loan the buyer truly assumes or takes the property subject to is handled differently, and even then the part above your basis is a year-one payment (Temp. Reg. §15a.453-1(b)(3)(i); IRS Pub. 537). Add ordinary depreciation recapture, which is taxed in year one regardless of payments (§453(i)), and year one can carry a large bill against a modest amount of cash.

Rule of thumb. Size the down payment so the cash left after paying off your loan and closing costs covers the year-one tax on the gain, the recapture and the interest, with something left over.

Set the interest rate

The floor is the AFR. A seller note must carry adequate stated interest. If it does not, part of the principal is recharacterized as interest, which moves income from capital gain to ordinary interest (§§483, 1274). For a sale, the test rate is the lowest applicable federal rate for the 3-month period ending with the month of the binding written contract (§1274(d)(2)). The term of the note picks the rate: short-term up to 3 years, mid-term over 3 up to 9 years, long-term over 9 years (§1274(d)(1)).

A 5 or 7 year balloon note tests against the mid-term rate. Check the current month in the AFR table and the rules in seller financing interest rate and the AFR.

The market rate is higher. You are taking a lender's risk without a lender's diversification. Sellers usually price above the AFR and somewhere near, or above, what a bank would charge the same buyer. A buyer who cannot get a bank loan is, by definition, a riskier borrower. The interest is ordinary income to you each year.

Amortization vs balloon

Amortization sets the monthly payment. A 25 or 30 year amortization keeps payments affordable. The balloon sets when the rest is due. Most seller notes do not run the full amortization; they balloon after 3 to 10 years, when the buyer is expected to refinance.

5-year vs 7-year balloon. Five years gets you paid sooner. Seven gives the buyer more time to build a track record, season the property and qualify for a bank loan, which lowers the chance the balloon fails. Either way, the balloon brings most of the remaining gain into one tax year. If spreading the tax is a goal, a longer balloon or a fully amortizing note does more of it. See seller financing balloon payment.

If the property is the buyer's home, Regulation Z's three-property seller exclusion requires the loan to be fully amortizing, which rules out a balloon under that exclusion; the one-property exclusion for a natural person, estate or trust does not (12 CFR §1026.36(a)(4), (a)(5)). See seller financing rules and Dodd-Frank.

Secure the note

The note is the promise; the security is what you can do if the promise breaks.

• First lien position. Your deed of trust or mortgage should be recorded and, ideally, first. If a bank lends too, you will usually be second, and the bank's lien comes ahead of yours in foreclosure. See seller carry-back.
• Deed of trust or mortgage. In deed-of-trust states, a power of sale lets a trustee foreclose without going to court. Use a title company or attorney to prepare and record it, and get a lender's title policy.
• Taxes and insurance. Require the buyer to insure the property with you named as mortgagee or loss payee and to keep property taxes current. An escrow or impound account for both, collected with each payment, lets you see problems early.
• Due-on-sale clause. Put one in your own note so the buyer cannot resell the property and leave you holding a loan to someone you never approved.
• Personal guaranty. In a business sale, or when the buyer is an LLC, get a personal guaranty from the owners. Consider a lien on business assets too. See seller financing a business sale.
• Default terms. Grace period, late fee, default interest, notice and cure periods, and who pays collection costs. See what happens when the buyer defaults.

The full list of clauses is in seller financing note terms and the seller financing addendum.

Prepayment terms and the tax they trigger

Most buyers want the right to prepay, and most notes allow it. That right is the part of seller financing that most often breaks a seller's tax plan. When the buyer pays off early, all remaining principal arrives in that year, and so does all remaining deferred gain. A buyer who refinances in year two can undo the spread you planned over ten.

Ways to manage it:

• Lockout. No prepayment for the first few years.
• Prepayment premium. A fee that declines over time. Check state law for residential limits.
• Partial prepayment caps. Limit extra principal in any one year.
• Accept it. An early payoff also ends your credit risk sooner.

Know too that the buyer's early payoff is not your only trigger. Selling or giving away the note triggers the remaining gain (§453B(a)), and borrowing against it can count as a payment on larger sales (§453A(d)). See selling a promissory note.

Plan the servicing

Someone has to collect payments, split interest and principal, track taxes and insurance, send year-end statements and chase late payments. A third-party servicer keeps records clean and makes the note easier to sell later. See seller financing loan servicing.

A sample term sheet

A term sheet like this is also how to write a seller financing offer: put these terms in the purchase agreement or addendum so both sides agree before escrow opens. Have a real estate attorney draft the note and security instrument.

Worked example with tax per year

Simple example. You sell investment land for $1,000,000. Your adjusted basis is $400,000, so your gross profit is $600,000 and your gross profit ratio is 60%. You owe $150,000 on a loan that is paid off at closing out of the $250,000 down payment. The buyer signs the $750,000 note in the term sheet above. Closing is January 1, with 12 payments a year. For illustration, we assume a flat 20% combined tax rate on the gain; your actual rate depends on your brackets, state and the 3.8% net investment income tax, and interest is taxed separately at ordinary rates.

Three lessons:

1. Year one is heavier than the cash suggests. You received $250,000 at closing, but $150,000 went to your lender. Your net cash was $100,000, and the gain tax alone is $31,377, before tax on $52,137 of interest.
2. The balloon is where the gain lives. Two-thirds of the gain is recognized in year 7. A 7-year balloon on a 25-year amortization is mostly a deferral, not an even spread.
3. An early payoff moves the bill. If the buyer refinanced in year 3, you would receive $726,223 of principal that year and recognize $435,734 of gain in year 3 instead of spreading it through year 7.

The 7% rate clears the mid-term AFR (4.49% for September 2026, 4.61% for October 2026), so no interest is imputed. Run your own version, with your brackets and state, in the owner financing calculator for the schedule and the seller financing calculator for the tax.

Getting the installment tax treatment without making the loan

Look at what the structuring above is trying to do. The lockout, the prepayment premium, the long balloon and the guaranty all exist to protect two things: the tax spread and your chance of being paid. Many sellers carry a note mainly for the first. A structured installment sale gives you that without the second problem.

The buyer pays the full price at closing, usually with a normal bank loan. You receive payments from an assignment company on a schedule you choose before closing (level, stepped, a deferred start or a balloon in the year you want it). The gain is reported on the installment method (§453) as payments arrive. No buyer default, no foreclosure, no servicing, and no early payoff that dumps the deferred tax into one year.

Seller financing is still the right structure in some deals: a buyer you know well, a large down payment, a deal where you want room to renegotiate, or a buyer who cannot get a bank loan at all. But if the buyer can finance with a bank and your main goal is the tax spread, it is worth pricing both.

What to know before you choose it. It has to be set up before closing; a note you already hold cannot be converted. The payments are locked in: you can't speed them up, borrow against them, pledge them or cash them out, and that is what keeps the deferral intact. There is no free look after closing: once the sale closes, the structure cannot be undone. The payments depend on the assignment company's ability to pay. The structure rests on settled installment-sale law, but this specific assignment structure has no published IRS ruling, so have your CPA or tax attorney review the documents. A commission is built into the pricing: Hans is paid about 2.4% of the amount structured, only if a structured sale is funded; seller financing pays him nothing (see the disclosures).

Use the seller financing calculator to compare your note with the same schedule paid by a structured sale. The full comparison is in seller financing vs structured sale.

Bottom line

The best way to structure seller financing is to size the down payment for your loan payoff and year-one tax, price the rate above the AFR and near the market, pick a balloon the buyer can realistically refinance, secure the note in first position with taxes and insurance tracked, decide how much early payoff you will tolerate, and hire a servicer. Then check the tax each year: the balloon and any early payoff decide when most of your gain is taxed.

Questions to ask your CPA or attorney

• How much gain, recapture and interest will I report in the year of sale, and does the down payment cover the tax?
• Which AFR applies to this note, based on the contract date and term?
• If the buyer refinanced in year two or three, what would that year's tax be?
• Should the note include a lockout or prepayment premium, and is it enforceable in my state?
• Is my lien first, and what title insurance and recording do I need?
• If the buyer is an entity, what guaranty and collateral should I require?
• Would a structured installment sale written into this contract before closing give me the same tax spread with less risk?

Educational only, not tax, legal or investment advice. Examples are illustrative. Have your CPA or tax attorney review your facts before you act. Hans Goldstein is a licensed insurance agent (CA Insurance License #4273294) and is not a CPA or attorney. He is paid a commission only if a structured installment sale is funded; seller financing pays him nothing. Disclosures.