How an installment sale works
In an installment sale, the buyer pays you over time rather than all at once. Under IRC Section 453, you report gain as you receive each payment rather than recognizing the entire gain in the year of sale. Each installment payment is divided into three parts: return of basis, gain (capital gain or recapture), and interest. You pay tax on the gain and interest portions as they arrive.
The gross profit percentage — gross profit divided by the contract price — determines what share of each principal payment is gain. If your gross profit is $200,000 on a $500,000 sale price, the gross profit ratio is 40%, so 40 cents of every dollar of principal payment is taxable gain.
The critical exception: recapture is taxed in year one
Depreciation recapture (unrecaptured Section 1250 gain and Section 1245 gain) must be recognized in the year of sale, regardless of the installment election. You cannot spread the recapture portion over the payment period. Only the capital gain above and beyond the recapture amount qualifies for installment treatment. This is the most important limitation: if the recapture is large relative to the total gain, installment sales offer limited tax benefit.
When installment sales make sense
Installment sales work best when the capital gain above the recapture is substantial and you want to keep future income in lower rate brackets. They're also useful for diversifying a concentrated real estate position over time. Key risks: if the buyer defaults, you may have difficulty recovering the property or collecting; if tax rates rise, you could end up paying more tax on later installments than you would have paid up front. And since recapture must be recognized immediately, high-depreciation properties get limited installment benefit.
Frequently asked questions
Can I defer depreciation recapture with an installment sale?
No. Unrecaptured Section 1250 gain and Section 1245 recapture are recognized in full in the year of sale, even if the buyer pays over time. Only the capital gain above the recapture amount can be spread.
How is each installment payment taxed?
Each principal payment is split: a return-of-basis portion (tax free), a gain portion (taxable at capital gains rates), and interest income (taxed as ordinary income).
Is an installment sale better than a 1031 exchange?
A 1031 exchange defers 100% of gain including recapture; an installment sale only defers capital gain above recapture. The 1031 is generally more powerful if you plan to reinvest in real estate.
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.