What is an installment sale?
Section 453 of the tax code defines an installment sale as a disposition of property where at least one payment is received after the close of the tax year of the sale. The most common example is a seller-financed building sale: the buyer makes a down payment at closing and pays the rest over months or years.
If a sale qualifies, the installment method applies automatically unless you elect out. Each year you report only the part of the gain that matches the principal you received that year. Interest on the note is separate and is taxed as ordinary income when you receive it.
The installment method can’t be used in some situations. A real estate dealer can’t use it for property held for sale to customers, and it doesn’t apply to inventory, publicly traded stock or securities, or a sale at a loss.
How the installment method works
The installment method turns your total profit into a percentage and applies that percentage to every dollar of principal you collect. IRS Publication 537 walks through the steps, and you report them on Form 6252 for each year you receive a payment.
- Selling price: the full price, including cash, the note and any debt the buyer takes over.
- Adjusted basis: what you paid plus improvements, minus depreciation allowed or allowable.
- Gross profit: selling price minus adjusted basis and selling expenses.
- Contract price: the selling price minus any existing mortgage the buyer assumes, up to your basis. If the buyer assumes nothing, it equals the selling price.
- Gross profit percentage: gross profit divided by contract price.
- Taxable gain each year: principal received that year multiplied by the gross profit percentage. The down payment counts as a payment in the year of sale.
Worked example: a $3 million building sold on an installment note
An owner bought a building for $1,700,000 and has taken $500,000 of straight-line depreciation, so the adjusted basis is $1,200,000. The building sells for $3,000,000 with $150,000 of selling costs, for a gross profit of $1,650,000. The buyer assumes no debt, so the contract price is $3,000,000 and the gross profit percentage is 55%.
The seller receives a $600,000 down payment and carries a $2,400,000 note at 6.5%, interest only, with the full balance due at the end of year five. In the year of the sale, the seller reports 55% of the down payment, or $330,000 of gain. For the next three years the seller reports no gain but receives $156,000 a year of interest income. In year five, when the $2,400,000 balloon is paid, the seller reports $1,320,000 of gain.
The order matters. Treasury Regulation 1.453-12 says the gain from straight-line depreciation, called unrecaptured Section 1250 gain, comes out of each payment first. So all $330,000 reported in year one falls in the 25% layer. In year five, the remaining $170,000 of that layer is reported first, and the other $1,150,000 is regular long-term capital gain.
A seller in the top brackets every year owes about $417,700 in federal tax either way, the same as an outright sale: about $95,040 in year one and $322,660 in year five, including the 3.8% net investment income tax. The installment sale pushes most of the bill four years out, which is real money. It cuts the total tax only when spreading the gain keeps some of it in lower brackets or under the net investment income tax threshold.
| Year | Principal received | Gain reported (55%) | Type of gain |
|---|---|---|---|
| Year of sale | $600,000 | $330,000 | All unrecaptured Section 1250 gain (up to 25%) |
| Years 2 to 4 | $0 | $0 | Interest only: $156,000 a year of ordinary income |
| Year 5 (balloon) | $2,400,000 | $1,320,000 | $170,000 Section 1250 gain, $1,150,000 capital gain |
| Total | $3,000,000 | $1,650,000 | Same total gain as an all-cash sale |
What an installment sale cannot defer
An installment sale defers tax on the gain, but not on every part of it. Plan for these items in the year of sale.
- Ordinary income recapture: under Section 453(i), depreciation recapture taxed as ordinary income, such as Section 1245 recapture on items from a cost segregation study or bonus depreciation, is reported in full in the year of sale, even if you receive no cash that year.
- Interest: interest on the note is ordinary income each year you receive it.
- Debt relief over basis: if the buyer takes over a mortgage larger than your basis, the excess is treated as a payment in the year of sale.
- State tax: most states follow the federal installment rules, but if you move while the note is outstanding, check whether the state where the property sits still taxes the later payments.
The $5 million rule and other traps
Large installment sales come with extra rules. Under Section 453A, interest is charged on the deferred tax when installment notes from sales over $150,000 that arose during the year and are still outstanding at year-end total more than $5 million. On a large apartment sale, that interest can wipe out much of the benefit of waiting.
Section 453A also treats a pledged note as paid: if you use the note as collateral for a loan, the loan proceeds count as a payment and gain is recognized. Under Section 453B, selling or giving away the note also triggers gain. And selling to a related party, such as a family member, who resells within two years can accelerate your gain under Section 453(e).
If the buyer defaults and you take the property back, Section 1038 generally limits the gain you recognize, but the calculation is technical and your basis in the property resets. Talk to your CPA before you foreclose.
Electing out of installment sale treatment
You can report the full gain in the year of sale by electing out of the installment method. You do it by reporting the whole gain on Form 4797 or Schedule D, on a return filed by the due date including extensions. Revoking the election usually requires IRS approval.
Electing out can make sense when you have losses to absorb the gain this year, expect higher tax rates later or want a clean break from the note for tax purposes. For most sellers, though, deferral is the reason to carry a note in the first place.
Installment sale vs 1031 exchange vs outright sale
An installment sale is one of several ways to manage the tax on a building sale. They solve different problems and can sometimes be used together.
| Option | What happens to the tax | You end up with | Best for |
|---|---|---|---|
| Outright cash sale | All gain taxed in the year of sale | Cash | Sellers who want a clean exit or need the money now |
| Installment sale | Gain taxed as principal is received; interest taxed yearly | A secured note and payments | Sellers who want income and can wait to be paid |
| 1031 exchange | Gain deferred into replacement real estate | Another property | Owners who want to stay invested in real estate |
| Delaware statutory trust (via 1031) | Gain deferred into a passive interest | A share of a professionally managed property | Owners who want to stop managing but stay invested |
Combining an installment sale with a 1031 exchange
A note you receive in a 1031 exchange is not like-kind property, so it is boot. Treasury Regulation 1.1031(k)-1(j)(2) lets you report that boot on the installment method when the note comes through your qualified intermediary. Some sellers exchange most of their equity into a new property and carry a smaller note, deferring tax on the exchanged part and spreading the tax on the note. The structure has to be planned with your intermediary before closing.
What happens to an installment note when you die
An unpaid installment note does not get a stepped-up basis at death. Under Section 691, the deferred gain is income in respect of a decedent, so your heirs recognize the gain as they collect the payments, much as you would have. That is different from holding the building until death, when the property itself generally gets a stepped-up basis. If estate planning weighs heavily in your decision, review both paths with your advisors.
Selling your building on an installment basis
Skyline Capital Investments buys apartment buildings with five or more units across the country, and many of our offers include seller-carry terms that can be reported as an installment sale. The down payment, note amount, rate, payment schedule and balloon date all go in the letter of intent, so your CPA can model the tax year by year before you agree to anything.
Send the address and unit count through the form on this page or call (469) 660-2977. We typically respond within 48 hours, and we would be happy to show you an installment offer next to an all-cash offer.
Selling? Spread the tax with seller-carry terms
If a large tax bill is what is keeping you from selling, an installment sale may help. When you carry part of the price as a note, the gain is generally reported as you receive payments instead of all in the year of sale. Some parts of the gain, such as certain depreciation recapture, can still be due up front, so run the numbers with your CPA first.
Skyline Capital Investments buys apartment buildings with five or more units and can offer seller-carry terms, or a delayed closing that fits your 1031 timeline. Send the address and unit count and we typically respond within 48 hours. How seller financing works · Seller financing calculator.
Get A Seller-Carry Offer
