Balloon payment as an installment
In a seller-financed sale with a balloon payment, the balloon is simply a larger installment. Each payment you receive — including the balloon — is divided into three components: return of basis, recognized gain, and interest income. The gain portion equals the payment multiplied by the gross profit percentage (gross profit ÷ contract price).
Example: You sell a rental for $500,000 with $100,000 down and a $400,000 note ballooning in 5 years. Your adjusted basis is $200,000, gross profit is $300,000, and gross profit percentage is 60%. When the $400,000 balloon is paid, the taxable gain component is $400,000 × 60% = $240,000.
Depreciation recapture in the year of sale
Depreciation recapture cannot be spread over the installment period — it must be reported in full in the year of sale, even if you receive little or no cash that year. This is a common surprise for investors who think they're deferring everything.
The recapture amount reduces the remaining gain available for installment treatment. After recapture is recognized, the remaining gain is spread over future payments using the gross profit percentage. Report recapture on Form 4797; use Form 6252 for the installment portion.
Seller sells or dispenses with the note
If you sell the installment note to a third party (or gift it), the remaining deferred gain is immediately recognized at the time of disposition. The amount recognized is the FMV of the note minus your unrecovered basis in the note.
Similarly, if the buyer refinances the balloon and pays off the note early, the lump payment is still an installment payment — it triggers the gain recognition in that year, not all at once as an accelerated event. The difference between early payoff and selling the note matters for timing.
Frequently asked questions
Is depreciation recapture reported upfront or spread over payments?
Upfront — in the year of sale. Recapture cannot be deferred even in an installment sale. Only the remaining capital gain can be spread.
What is the gross profit percentage?
Gross profit divided by contract price. Gross profit is the selling price minus your adjusted basis and selling expenses. This percentage determines the gain portion of each installment payment.
What happens if I sell the installment note?
All remaining deferred gain is recognized immediately when you dispose of the note — there is no further installment deferral once the note changes hands.
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.