Seller Financing in Commercial Real Estate: Carryback Structures, Installment Sale Tax Treatment, and Pro Forma Modeling

Key Takeaways

What Seller Financing Actually Is

Seller financing is a loan from the seller to the buyer as part of the purchase transaction. Instead of receiving 100% of the purchase price at closing, the seller receives a portion in cash (funded by the buyer's equity and senior debt) and carries the balance as a note. The note is a promissory note with a stated principal amount, interest rate, payment schedule, maturity date, and security interest.

In commercial real estate, seller financing most commonly takes the form of a purchase money second mortgage (a junior lien on the property, subordinate to the senior mortgage) or a seller carryback note secured by a pledge of entity interests (similar to mezzanine debt, where the collateral is the buyer's ownership interest in the property-owning entity). The choice between these two forms depends on the senior lender's requirements.

Seller financing has been used in commercial real estate for decades, particularly in tight credit markets. It differs from institutional mezzanine debt and preferred equity in three ways: terms are bilaterally negotiated between buyer and seller, pricing reflects the seller's tax and liquidity motivations, and the buyer-seller relationship from the purchase negotiation persists into the lending relationship.

When Seller Financing Gets Used

Most institutional CRE transactions close with conventional equity and debt, and the seller receives 100% of the purchase price at closing. Seller financing emerges in specific situations:

• Wide bid-ask spread. The seller wants $12M. The buyer can only justify $10.5M based on current NOI and cap rate. Seller financing narrows the gap: the buyer pays $12M with a $1.5M seller note at 7.5% interest-only for 7 years. Discounted at a 13% market rate for comparable subordinate capital (the mezzanine rate used later in this article), that note is worth about $1.14M, a discount of about $0.37M, so the effective purchase price is about $11.6M. That is closer to the buyer's $10.5M valuation but does not close the gap; the rest has to come from price.

• Conventional subordinate capital is expensive or unavailable. In tight credit markets (2023 was a recent example), mezzanine lenders retreat and pricing spikes. A seller who is willing to carry a note at 7% to 8% provides cheaper subordinate capital than a debt fund pricing mezzanine debt in the mid-teens. The buyer gets a better blended cost of capital. The Federal Reserve Senior Loan Officer Opinion Survey is the standard quarterly gauge for tracking these credit-tightening cycles.

• Tax deferral. The seller has significant embedded capital gain and wants to defer tax recognition under IRC Section 453 (installment sale treatment). By receiving payments over 5 to 10 years rather than all at closing, the seller spreads the tax liability over the payment period. Tax deferral is a common motivation in seller-financed deals.

• Property challenges. Properties with significant deferred maintenance, environmental issues, zoning complications, or high vacancy may not qualify for conventional subordinate capital. A seller who knows the property and its issues may be willing to carry a note when an institutional mezz lender would not.

• Relationship transactions. Transactions between related parties, joint venture partners, or long-standing business relationships often use seller financing to simplify the capital stack and align incentives. Related-party sales carry tax limits on the installment method (see Installment Sale Tax Treatment below). The seller's willingness to carry a note signals confidence in the property and the buyer.

How the Note Is Structured

Every term in a seller carryback note is negotiable. There are no standardized forms (unlike CMBS intercreditor agreements or agency loan documents). The key terms:

The interest rate on the note is not entirely free-floating. The IRS requires seller notes to bear interest at least equal to the Applicable Federal Rate (AFR) for the term category matching the note's duration. Notes with a term of not over three years use the short-term AFR. Notes over three years but not over nine years use the mid-term AFR. Notes over nine years use the long-term AFR (IRC Section 1274(d)(1)). The rate is the lowest of the AFRs in effect for the three-calendar-month period ending with the month of the binding written contract (Section 1274(d)(2)). If the stated rate is below the applicable AFR, the IRS imputes interest at the AFR under Section 1274, converting a portion of what the parties characterized as principal into ordinary interest income for the seller and interest expense for the buyer (whose deductibility depends on how the property is used and on limits such as Section 163(j)). The annual-compounding mid-term AFR ran from 3.81% in January 2026 (Rev. Rul. 2026-2) to 4.61% in October 2026 (Rev. Rul. 2026-19), so the negotiated seller-note rates in this article (6% to 10%) sit above the floor. When the parties want to report more of each payment as principal and less as interest, they occasionally test the AFR floor, but the risk of recharacterization typically deters that.

Seller Carryback in the Capital Stack

A seller carryback note occupies the same position as mezzanine debt in the capital stack: between senior mortgage debt and common equity. The note is subordinate to the senior mortgage (either as a junior lien or as an unsecured obligation, depending on the senior lender's requirements).

The difference from institutional mezzanine debt is the relationship between the parties. A mezz lender is a third-party capital provider with no prior relationship to the property. A seller-lender is the former owner. That creates alignment (the seller knows the property) and potential conflict (the seller may have incentives that diverge from the buyer's).

Senior lender requirements for seller notes are generally similar to mezzanine debt requirements: the note must be subordinate, the seller must execute a subordination agreement or standstill, and the seller's remedies (foreclosure, acceleration) must be restricted during the senior loan term. A senior lender may require that the seller note be fully unsecured (no junior lien) to avoid any complications with the senior lender's first-lien position.

Installment Sale Tax Treatment (IRC 453)

The installment sale method under IRC Section 453 allows a seller who receives at least one payment after the tax year of the sale to recognize gain proportionally as payments are received, rather than recognizing the entire gain in the year of sale. This is the primary tax benefit of seller financing for the seller. The statute is codified at 26 U.S.C. Section 453; the IRS's plain-English summary is Publication 537.

The mechanics:

1. Gross profit ratio. The seller calculates the gross profit ratio: gross profit (selling price minus adjusted basis) divided by contract price, which equals the selling price when the buyer assumes none of the seller's debt. If the property was purchased for $8.5M 15 years ago, carries $2.5M of accumulated depreciation (adjusted basis $6M), and sells for $12M, the gross profit ratio is ($12M - $6M) / $12M = 50%. To keep the arithmetic readable, the examples in this article ignore selling expenses in the gain calculation; in practice they are added to basis and reduce the gain.
2. Gain recognition on each payment. Each payment received (principal, not interest) is treated as part sale proceeds and part return of basis. The taxable gain on each payment equals the payment amount multiplied by the gross profit ratio. On the $12M sale with a 50% gross profit ratio, $1M of principal received triggers $500K of taxable gain.
3. Interest is taxed separately. Interest received on the seller note is taxed as ordinary income in the year received. The interest component does not benefit from installment treatment.
4. Depreciation recapture. Recapture income taxed as ordinary income (Section 1245 property, and any Section 1250 additional depreciation) is recognized in full in the year of sale under IRC Section 453(i), regardless of the installment method. Unrecaptured Section 1250 gain, taxed at a maximum 25% federal rate, is not accelerated. Under the IRS instructions for Schedule D it is the first gain recognized as installment payments are received. On properties with significant accumulated depreciation, the cash received at closing therefore carries the higher-rate gain.

Two limits matter when the buyer is related to the seller. In an installment sale of depreciable property between related persons, the installment method does not apply and all payments are treated as received in the year of the sale, unless the seller establishes that avoiding federal income tax was not one of the principal purposes of the disposition (IRC Section 453(g)). If a related buyer resells the property before the seller has received all payments, the resale proceeds can be treated as received by the seller at the time of the second sale, generally if it occurs within two years of the first (Section 453(e)). Separately, the installment method is the default for a qualifying sale. The seller may elect out under Section 453(d) and report all the gain in the year of sale.

Depreciation Recapture Deep Dive

Depreciation recapture is the single most misunderstood mechanic in seller-financed CRE transactions. Sellers see the installment method described as "deferring gain," assume the deferral applies to all gain, and get an unpleasant surprise when the accountant delivers a large Year 1 tax bill on a deal where they only received a fraction of the purchase price in cash.

The rule is set out in IRC Section 453(i): any recapture income attributable to the sale is recognized in the year of sale, not on the installment method. Section 453(i)(2) defines recapture income as the amount that would be treated as ordinary income under Section 1245 or 1250 if all payments were received in the year of disposition. For real property depreciated straight-line, the relevant bucket is unrecaptured Section 1250 gain, which is not ordinary income. It is long-term capital gain taxed at a maximum rate of 25% federal under IRC 1(h), plus applicable state tax and (for high earners) the 3.8% Net Investment Income Tax under IRC 1411. Straight-line depreciation on real property produces no Section 1250 ordinary-income recapture, so Section 453(i) accelerates nothing in the example in this article. The IRS instructions for Schedule D treat the gain in each installment payment as unrecaptured Section 1250 gain until the total has been used in full.

The mechanical steps a seller and their accountant work through:

1. Compute total accumulated depreciation. Pull the depreciation schedule from every prior return. For a property held 15 years and depreciated straight-line over 39 years, roughly 38% of the original depreciable basis has been recovered as deductions.
2. Segregate unrecaptured 1250 gain from remaining capital gain. The full amount of accumulated straight-line depreciation is unrecaptured 1250 gain, up to the total realized gain. Any remaining gain above that is standard long-term capital gain.
3. Allocate each payment to the 25% bucket first. The gain in each installment payment is treated as unrecaptured 1250 gain until the $2.5M is used in full. A seller who receives 80% of the price in cash recognizes $4.8M of gain in the year of sale, and all $2.5M of the 25% bucket falls in that year. A seller who receives little cash in the year of sale recognizes little gain, and the 25% bucket is spread over the collection period instead.
4. Apply the gross profit ratio to the payments. The gross profit ratio determines how much gain each payment carries. Once the 25% bucket is used, the remaining gain is taxed at the 20% long-term rate (plus NIIT and state) as the later payments arrive. In the example, the $1.2M of gain tied to the balloon is all in the 20% bucket.
5. Handle cost-segregation carve-outs separately. If the seller previously performed a cost segregation study, depreciation taken on 5- and 7-year components is Section 1245 recapture, taxed as ordinary income at the seller's marginal rate and recognized in the year of sale under Section 453(i). Any depreciation on 15-year land improvements in excess of straight-line is Section 1250 additional depreciation, which is also ordinary recapture. The $2.5M in this article's example is straight-line depreciation with no such components.

Liquidity planning matters. A seller carrying a large note on a heavily depreciated property can face a six- or seven-figure tax bill in the year of sale with only partial cash to fund it. Size the cash-at-close portion to cover the tax on the gain it carries (including any ordinary recapture on cost-segregated components) plus closing costs plus reserves. Model the year-of-sale tax first, then size the note.

The Seller's After-Tax Return

The seller's motivation for carrying a note is often primarily tax-driven. The economic analysis compares two scenarios: (a) selling for $12M all-cash and paying the full tax liability in Year 1, or (b) selling for $12M with a $2.4M note and deferring a portion of the gain.

In Scenario A (all-cash sale), the seller receives $12M less closing costs and pays the full tax on the $6M gain in the year of sale. The build-up is worked in the next section: tax of approximately $1.85M and net after-tax proceeds of approximately $9.9M after $240K of selling costs.

In Scenario B (with seller note), the seller receives $9.6M cash at closing plus a $2.4M note at 7.5% over 7 years. The year-of-sale tax liability is reduced because only 80% of the gain ($4.8M of $6M) is recognized at closing. The deferred gain ($1.2M) is recognized in Year 7, when the balloon returns the principal; the note is interest-only, so no principal is collected earlier. The seller also earns $180K annually in interest income (taxed as ordinary income).

The after-tax benefit of the seller note depends on the seller's tax rate, the interest rate on the note, and the seller's alternative investment returns. If the seller can earn more after tax by investing the proceeds elsewhere than the note's after-tax yield, the note is suboptimal. If the tax deferral benefit exceeds the opportunity cost, the note is accretive. The worked example below shows how modest that benefit can be: the deferred tax is about $346K, and the coupon is taxed at ordinary rates.

All-Cash vs Installment: After-Tax Numbers

Abstract statements about tax deferral do not settle a negotiation. Sellers make the choice with a side-by-side after-tax IRR comparison. This section works both scenarios on the $12M sale with $2.5M of accumulated depreciation and $6M of embedded gain (an $8.5M original cost less $2.5M of depreciation leaves a $6M adjusted basis), holding the seller's alternative investment yield constant so the comparison is like-for-like.

Assumptions used throughout: federal long-term capital gain rate 20% plus 3.8% NIIT plus a 5% state rate (a California mid-tier taxpayer would run higher, no-tax states would run lower), or 28.8% on gain other than unrecaptured Section 1250 gain. Unrecaptured Section 1250 gain is taxed at the 25% maximum federal rate under IRC 1(h) plus 3.8% NIIT plus 5% state, or 33.8%. Note interest is ordinary income taxed at 37% federal plus 3.8% NIIT plus 5% state, or 45.8%. The depreciation is straight-line with no cost-segregated components. Selling costs reduce cash but, to keep the arithmetic readable, are not netted against the gain. The seller's after-tax reinvestment yield on liquid proceeds is assumed to be 5.0% (an illustrative assumption). Timing convention: tax for the year of sale is paid at closing, interest coupons arrive at the end of Years 1 through 7, and the balloon arrives at the end of Year 7. Seller note terms: $2.4M at 7.5% interest-only for seven years with balloon at maturity. Buyer creditworthy, note performs.

Scenario A. All-cash sale.

The seller receives $12.0M gross at closing. Selling costs of 2% ($240K) leave $11.76M net cash. In the year of sale the seller recognizes the full $6M gain: $2.5M as unrecaptured Section 1250 gain taxed at a blended 33.8% (25% federal + 3.8% NIIT + 5% state) for $845K, and $3.5M as long-term capital gain taxed at a blended 28.8% (20% + 3.8% NIIT + 5% state) for $1.008M. Total tax: $1.853M. Net after-tax proceeds at closing: $9.91M.

The seller invests those proceeds at 5.0% after-tax equivalent for seven years. Ending wealth: $9.91M x (1.05)^7 = $13.94M. That is the benchmark.

Scenario B. $2.4M seller carryback at 7.5%.

The seller receives $9.6M cash at closing. Selling costs still $240K, so net cash at close is $9.36M. The gross profit ratio is gross profit divided by contract price: $6M / $12M = 50%. The $9.6M received in the year of sale therefore carries $4.8M of gain (50% x $9.6M). Under the IRS instructions for Schedule D, installment gain is treated as unrecaptured Section 1250 gain until the full $2.5M has been used, so the first $2.5M of gain is taxed at 33.8% for $845K and the remaining $2.3M at 28.8% for $662K. Total tax in the year of sale: $1.507M. Net cash available for reinvestment after tax: $9.36M - $1.507M = $7.85M. Section 453(i) accelerates nothing here, because straight-line depreciation produces no ordinary-income recapture.

The note pays $180K per year of interest in Years 1 through 7 (taxed as ordinary income at 45.8%, leaving $97.6K per year net) and no principal until maturity. In Year 7 the balloon returns $2.4M of principal, triggering recognition of the remaining $1.2M of gain (50% x $2.4M). All of it falls in the 28.8% bucket, because the 25% bucket was used in full in the year of sale: tax of $346K. Net proceeds from the balloon after tax: $2.4M - $0.346M = $2.054M. Total tax across both years is the same $1.853M as in Scenario A; the note only moves $346K of it from the year of sale to Year 7.

Ending wealth calculation for Scenario B: reinvest $7.85M at 5.0% for seven years = $11.05M, plus the future value of seven year-end net coupons of $97.6K reinvested at 5.0% (approximately $0.79M by Year 7), plus $2.05M net balloon. Ending wealth: $13.90M.

The two scenarios sit within noise of each other (Scenario A ends about $0.04M ahead; rows are rounded and may not sum exactly), which is exactly the point. At a 5% reinvestment yield and a 7.5% note coupon taxed at 45.8%, the tax deferral benefit is almost exactly offset by the opportunity cost of tying up capital in the note. Where the seller comes out ahead is when reinvestment yields are lower (at a 3.5% after-tax yield, Scenario B ends at about $12.80M against $12.60M for Scenario A), when the note coupon is higher (at 9%, Scenario B ends at about $14.06M against $13.94M), or when the seller is at an age where deferring recognition into a lower-tax retirement year has value beyond simple time value.

The seller comes out behind when the buyer's credit is weak (default risk depresses the true expected value of the note), when reinvestment yields are strong (public equity returns of 10%+ after tax during a bull run), or when the seller has a specific reinvestment target (a 1031 replacement property already identified) that offers a higher return than the note coupon. Run the numbers to give the seller a defensible framework for the decision, not to prove one answer.

The Buyer's Blended Cost of Capital

For the buyer, seller financing reduces the blended cost of capital by replacing expensive subordinate capital (mezz at 13%, preferred equity at 15%) with cheaper seller-financed capital (7% to 9%). These are illustrative 2026 assumptions. The blended cost improvement depends on the size of the seller note relative to the capital stack.

On a $12M acquisition with a $2.4M seller note at 7.5%:

• Without seller financing: $7.2M senior (6.5%) + $2.4M mezz (13%) + $2.4M equity. Blended cost of debt: 8.1% ($7.2M at 6.5% plus $2.4M at 13% is $780K of interest on $9.6M).
• With seller financing: $7.2M senior (6.5%) + $2.4M seller note (7.5%) + $2.4M equity. Blended cost of debt: 6.75% ($7.2M at 6.5% plus $2.4M at 7.5% is $648K of interest on $9.6M).

The reduction of about 140 bps in blended debt cost flows directly to the equity return. In the worked example below, the saving of $132K per year on $2.4M of equity lifts the 5-year equity IRR from about 10.1% to about 14.7%.

Worked Example: $12M Retail Acquisition

Consider a 30,000 SF anchored retail strip center. Purchase price: $12M. In-place NOI: $840K. Going-in cap rate: 7.0%. The seller purchased the property for $8.5M in 2011 and has $2.5M of accumulated depreciation (adjusted basis: $6.0M). The gain on sale is $6.0M.

The buyer proposes a $2.4M seller carryback note (20% of the purchase price) at 7.5%, 7-year term, interest-only with a balloon at maturity. The seller accepts because installment treatment defers $1.2M of the $6.0M gain, about $346K of tax, until the balloon in Year 7.

Annual senior debt service: $7.2M at 6.5%, 25-year amortization = approximately $583K. Annual seller note payment: $180K (IO). Total debt service: $763K. Cash flow to equity: $840K - $763K = $77K. Cash-on-cash: 3.2%.

Compare to the same deal with $2.4M of mezzanine debt at 13% IO: annual mezz payment = $312K. Total debt service: $895K. Cash flow to equity: negative $55K. The seller note saves the buyer $132K annually in debt service, turning a negative-cash-flow deal into a positive one.

Assume Year 1 NOI of $840K growing 2.5% annually, a 5-year exit priced at forward (Year 6) NOI and a 7.25% exit cap, and closing costs of 1.5% of the sale price (an illustrative assumption). The gross sale price is approximately $13.1M. After senior payoff ($6.52M amortized balance), seller note payoff ($2.4M, repaid at par ahead of its Year 7 maturity), and closing costs, equity receives approximately $4.0M on a $2.4M investment. Equity IRR: approximately 14.7%. With the mezz alternative, the negative Year 1 cash flow and higher debt service reduce the equity IRR to approximately 10.1%, a gap of about 450 bps. No senior loan prepayment cost is modeled; a Year 5 exit from a 10-year senior loan could trigger one. Both IRRs fall short of the 16% target in the capital stack table, so the buyer would need a lower price or stronger NOI growth to reach it; the seller note narrows the shortfall.

Wraparound Mortgage Variants

A wraparound mortgage (sometimes called a "wrap") is a structural variant of seller financing where the seller keeps the existing senior mortgage in place and writes a new, larger note to the buyer that "wraps around" the underlying senior debt. The seller collects a blended payment from the buyer, remits the senior payment to the original lender, and pockets the spread. Wraps are common in residential and small-balance commercial deals, occasionally seen in mid-market CRE, and largely absent from institutional transactions.

The mechanical structure of a wrap:

1. The seller has an existing $5M senior mortgage at 4.5% (a loan originated in the low-rate era pre-2022 that is not assumable in the conventional sense).
2. The buyer acquires the property for $8M. Instead of paying off the senior mortgage at closing, the seller and buyer document a $7M wrap note from the seller to the buyer at 7.0%. The buyer contributes $1M of equity.
3. The buyer makes monthly payments to the seller on the $7M wrap note. The seller continues to make monthly payments on the underlying $5M senior mortgage. The spread between the wrap rate and the senior rate accrues to the seller.
4. When the wrap matures (or the underlying senior mortgage matures, whichever comes first), the buyer refinances or pays off the seller in full, at which point the seller retires the underlying senior mortgage.

Wraps are attractive when the underlying senior loan is at a substantially below-market rate. With senior CRE rates at 6.0% to 6.75% in 2026 (the illustrative range used in the rate section below), a legacy 3.5% to 4.5% loan lets the seller offer a wrap note priced near or below new senior debt and still earn a spread. In the example above, the $7M wrap at 7.0% pays the seller $490K of annual interest against $225K of interest on the $5M senior loan, a spread of $265K on roughly $2M of net seller capital (about 13%), interest-only basis. That spread, not a lower cost to the buyer, is where the economics of a wrap sit.

The primary risk in any wrap is the due-on-sale clause in the underlying senior mortgage. Institutional CRE loan documents commonly contain a due-on-sale clause that permits the senior lender to accelerate the loan upon transfer of the underlying property. A wrap that transfers the property can result in acceleration of the senior loan and unwind the entire transaction. Many loan documents also treat transfers of direct or indirect ownership interests in the borrower as transfers, so moving entity interests instead of the property does not reliably avoid the clause. Whether any structure holds depends on the specific senior loan documents, the borrower entity structure, and the applicable state law. Get an opinion of counsel before assuming the wrap survives senior-lender scrutiny.

A second risk unique to wraps is the credit exposure the buyer takes on the seller. If the buyer pays the seller and the seller fails to remit to the senior lender, the senior lender forecloses and the buyer loses the property despite having paid in full. Wrap agreements typically address this by requiring the buyer to pay a servicing agent (title company, third-party servicer) who splits the payment between the senior lender and the seller. That structure removes the buyer's credit exposure to the seller but adds transaction friction and cost. On a wrap of this size, third-party servicing is the prudent structure.

Subordination and Standstill Negotiations

Every seller carryback note in an institutional CRE transaction has to earn the senior lender's consent. The senior lender's concern is straightforward: the seller-lender is a creditor with the ability to sue, foreclose, or seek other remedies in the event of default, and any such action can interfere with the senior lender's own remedies or reduce the property's value. The senior lender's protection comes from a subordination agreement, a standstill agreement, or both, documented in a single subordination and standstill agreement or a bespoke intercreditor agreement.

The core terms the senior lender imposes on the seller-lender:

• Lien subordination. The seller's lien on the property (if any) is expressly subordinate to the senior mortgage. In the event of a foreclosure of the senior mortgage, the seller's lien is wiped out.
• Payment subordination in default. If the senior loan is in default, the buyer is prohibited from making payments to the seller. Interest that accrues during the default period may be capitalized or forgiven depending on the agreement. Well-drafted seller notes address this explicitly; poorly drafted ones create a payment paradox where the buyer is prohibited from paying under the senior loan but obligated to pay under the seller note.
• Standstill period. The seller agrees not to exercise any remedies (sue, foreclose, accelerate, seek judgment) for a negotiated standstill period, for example 90 to 180 days after a default. The purpose is to give the senior lender time to work out the loan without a competing junior creditor complicating matters.
• Limits on recourse against the buyer. Anti-deficiency rules in some states limit what a lender can recover from a borrower beyond the collateral. Those rules protect the borrower, here the buyer, and they restrict the seller-lender's remedies. Counsel should confirm what recourse is actually available on the seller note, and the senior lender will usually want any recourse remedies to fall under the standstill.
• Cure rights. The seller receives notice of any senior loan default and typically has the right (but not the obligation) to cure the senior default and step into the senior lender's position. This is functionally identical to the cure rights a mezzanine lender receives under a standard intercreditor.
• Restriction on modifications. The seller cannot modify the terms of the seller note (rate, term, amortization, security) without senior lender consent. Similarly, the buyer cannot modify the senior loan in ways that would materially prejudice the seller without seller consent.

The negotiation dynamic between senior lender and seller-lender is asymmetric. The senior lender has the leverage: no consent, no deal. The seller wants to close because closing produces the tax deferral benefit that motivated the carryback in the first place. Sellers who dig in on subordination terms typically discover that the senior lender's requirements are non-negotiable table stakes, drawn from the senior lender's standard-form documents. The room for negotiation is at the margins: length of standstill (90 vs 180 days), scope of cure rights, mechanics of default notification. The core subordination is not up for debate.

Push back on drafting quality. Standard intercreditor forms are mezzanine-focused and contain provisions that make sense for a third-party institutional mezz lender but not for a seller-lender. A seller without specialized counsel can sign a subordination agreement that prevents any collection remedy for the life of the senior loan, converting the seller note into an unsecured, non-callable IOU. Hire counsel who has done these deals before.

Negotiation Dynamics: Who Has Leverage

Seller financing is a negotiated instrument, and the terms reflect who has leverage at the time of the transaction. Understanding the negotiation dynamics helps both sides avoid over-reaching and under-reaching.

When the seller is motivated.

A seller who needs to sell (estate settlement, portfolio wind-down, forced sale, tax-year timing constraint) has diminished leverage. Buyers extract better carryback terms. Illustrative patterns (not survey data):

• Larger note as a share of price. Motivated sellers accept carrybacks at the high end of the range (25% to 30% of price); unmotivated sellers rarely go above 20%.
• Lower coupon. Motivated sellers accept 6% to 7% on the note; unmotivated sellers push for 8% or above.
• Longer term. Motivated sellers accept 7- to 10-year terms; unmotivated sellers prefer 3- to 5-year terms to get their capital back sooner.
• Less restrictive prepayment. Motivated sellers accept freely prepayable notes; unmotivated sellers seek yield-maintenance or minimum-interest-period provisions.
• Weaker security. Motivated sellers accept unsecured notes or pledges of entity interests only; unmotivated sellers demand junior mortgages.

When the buyer is motivated.

A buyer who needs the deal to pencil (tight capital stack, thin returns, 1031 exchange timeline pressure) has diminished leverage. Sellers extract better carryback terms in the opposite direction: smaller note, higher coupon, shorter term, tighter prepayment provisions, stronger security. The buyer accepts unfavorable terms because the alternative (walking from the deal, losing the 1031 identification, missing the tax year, failing to deploy fund capital before an equity commitment expires) is worse than accepting an expensive carryback.

Broker-facilitated conversations often surface the leverage asymmetry before either side commits. A skilled broker will elicit the motivation from both sides during the LOI stage and use it to structure the note in a way that lets both sides believe they got a fair outcome. The National Association of REALTORS Commercial market data tracks broader transaction volume and pricing trends that inform where the leverage sits in the current market cycle.

The equal-leverage midpoint.

In an equal-leverage transaction (both sides motivated to close but neither desperate), an illustrative market-clearing seller carryback in 2026 might look like: 15% to 20% of purchase price, 7.0% to 8.0% coupon, 5- to 7-year term, interest-only with balloon at maturity, freely prepayable after 24 months, secured by a pledge of entity interests, with a standard subordination agreement and a 90-day standstill. Any deal materially outside those parameters is signaling that one side has more leverage than the other, and the party on the wrong side of the asymmetry should recognize the signal and either walk or extract compensating concessions elsewhere in the deal.

The 2026 Rate Environment

Seller financing is more attractive to buyers when the spread between the seller-note coupon and market subordinate-capital rates is wide. That spread has moved substantially over the last four years, and the 2026 environment is a specific point on that arc worth naming explicitly. The rate ranges in this section are illustrative assumptions used for the examples, not survey data, except where a source is linked.

From early 2019 through April 2022 the 10-year Treasury yield stayed below 3% (it first closed at or above 3% again on May 5, 2022, per FRED series DGS10). In that period, senior CRE debt priced in the 3.5% to 4.5% range, mezzanine debt at 8% to 10%, and preferred equity at 10% to 12%. Seller notes typically priced at 5% to 6%, roughly 350 bps inside institutional mezz at the midpoints of the two ranges, so tax deferral as much as coupon arbitrage was the reason to carry a note.

Through 2023 and 2024 the picture inverted. Senior CRE debt moved to 6.5% to 7.5%, mezzanine debt to 13% to 16%, and preferred equity to 14% to 18%. The Federal Reserve SLOOS reported successive quarters of tightening standards on CRE loans, with net percentages of banks tightening standards on nonfarm nonresidential loans exceeding 60% at the peak. Seller carrybacks priced at 6% to 7% became a genuine bargain relative to institutional mezz at 14%. Deals that would not have penciled with conventional subordinate capital penciled with a seller note.

In 2026 conditions have eased somewhat but not fully normalized. The July 2026 SLOOS reported that banks generally eased standards for commercial real estate loans, with a moderate net share easing standards on nonfarm nonresidential loans, after the January and April 2026 surveys showed nonfarm nonresidential standards basically unchanged. Senior debt has moved back toward 6.0% to 6.75%. Mezzanine debt has retreated toward 11% to 13%. Preferred equity toward 12% to 15%. Seller carrybacks are pricing at 7% to 9%, roughly 400 bps inside institutional mezz at the midpoints of the two ranges, versus roughly 800 bps during the 2023 to 2024 stress period. The spread has narrowed from that peak, but the case for seller financing on tax and structural grounds remains intact.

Seller financing tends to be more attractive when institutional mezz is scarce or expensive. In easy-credit environments (early 2022, 2015 to 2019), institutional mezz is cheap and abundant, and buyers use seller financing only for its tax benefits. In tight-credit environments (2023 to 2024, 2008 to 2010), institutional mezz retreats and seller financing fills part of the gap. Buyers who want to normalize seller financing as a repeatable capital source across cycles do it best by building relationships with recurring sellers (fund exits, family-office rebalances, generational transfers) who benefit from installment treatment and treat carrybacks as a standard part of their exit toolkit.

1031 Exchange Interaction

A seller who intends to do a 1031 exchange defers gain by identifying and acquiring replacement property within the 45/180-day windows. Installment sale treatment applies only to the part of the gain that the exchange does not defer.

A seller can combine the two, but the note is boot. A buyer's installment obligation received in the exchange is property other than like-kind property, so under IRC Section 1031(b) the gain it represents does not qualify for nonrecognition under Section 1031(a). That gain may still be reported on the installment method as payments are received: Section 453(f)(6) provides that like-kind property is not treated as a payment and adjusts the contract price and gross profit, and Treas. Reg. Section 1.1031(k)-1(j)(2) (Example 4) reaches this result for a buyer's 10-year installment obligation delivered to the seller along with replacement property. The cash received at closing is used to acquire replacement property under Section 1031; the note cannot fund replacement property. The gain tied to the note is deferred by the installment method, not by the exchange.

This requires coordination between the qualified intermediary (QI) handling the 1031 exchange and the closing attorney managing the seller note. Plan on the note being reported as boot, and have the exchange documents and the seller note agree on how it is delivered and reported.

Five Mistakes Practitioners Make

1. Ignoring depreciation recapture and bucket ordering. Installment sale treatment does not defer ordinary-income recapture: under IRC Section 453(i), Section 1245 recapture (including cost-segregated components) and any Section 1250 additional depreciation are recognized in the year of sale. Unrecaptured Section 1250 gain is not accelerated, but it is the first gain recognized as payments arrive. On a property with $2.5M of accumulated depreciation and 80% of the price received in cash, the year-of-sale gain of $4.8M includes all $2.5M of that 25% bucket, and the tax is about $1.5M. Model the buckets and their ordering separately.

2. Failing to subordinate the note to the senior mortgage. The senior lender will require that the seller note be subordinate to the senior mortgage. If the note is not properly subordinated (via a subordination agreement, standstill, or structural subordination through entity-level documentation), the senior lender may refuse to close. This is a documentation issue. Get it right before closing.

3. Not modeling the balloon payment. Most seller carryback notes are interest-only with a balloon at maturity. The balloon creates a refinancing event that must be modeled in the pro forma. If the note matures in Year 7 and the property's value has declined, the buyer may not be able to refinance the balloon. Model the balloon as a discrete cash outflow and stress-test the refinancing assumption.

4. Underpricing the note from the seller's perspective. A seller note at 7% may seem cheap relative to market mezz rates. But the seller should compare the note's after-tax yield to their after-tax alternative investment return, not to the buyer's cost of mezz. If the seller can earn 9% after tax in the public markets, the 7% note is suboptimal even with the installment sale benefit. Model the seller's after-tax return to ensure the terms work for both sides.

5. Assuming seller financing is available on any deal. Seller financing requires a willing and able seller. The seller must have the liquidity to defer a portion of the proceeds, the tax position to benefit from installment treatment, and the risk tolerance to carry credit exposure to the buyer. Many institutional sellers (REITs, funds with redemption obligations, estates with distribution requirements) cannot carry notes. Confirm the seller's ability before incorporating seller financing into the capital stack.

Model It in Apers

Related Articles

• Mezzanine Debt and Intercreditor Agreements. The institutional alternative to seller financing. How mezz compares on pricing, enforcement, and senior lender consent.
• Preferred Equity: Priority of Payments and Redemption. The equity-form alternative. How preferred equity compares to seller notes on cost and governance.
• 1031 Exchange Mechanics. How seller financing interacts with 1031 exchange planning. The partial 1031 plus installment sale combination.
• 1031 Boot and Basis Carryover. The tax mechanics of boot recognition when combining a 1031 exchange with a seller carryback note.
• C-PACE Financing. Another non-traditional subordinate capital source. How C-PACE compares to seller financing on cost, term, and structure.