How the installment sale method works
Under IRC § 453, if you receive at least one payment after the tax year of sale, you may report the gain using the installment method. Each payment you receive is allocated into three parts: (1) return of basis (non-taxable); (2) gross profit (taxable gain); and (3) interest (ordinary income). The gross profit ratio determines what fraction of each principal payment is taxable.
Example: Sell a rental for $400,000 with a $60,000 basis and a $340,000 gain. Gross profit ratio = $340,000 / $400,000 = 85%. Each dollar of principal received is 85 cents of taxable gain. If you receive $80,000 down, that's $68,000 of gain recognized in year one from the principal alone.
Depreciation recapture cannot be spread
This is the critical caveat: depreciation recapture (Section 1245 and 1250) must be recognized in full in the year of sale, regardless of how much cash you actually receive. If you have $50,000 of accumulated depreciation, all $50,000 is taxable in year one — even if you only received a $20,000 down payment.
Only the gain above the recapture amount (the capital gain portion) can be spread over the installment period.
Interest income and the AFR requirement
The interest rate on a seller-financed note must equal at least the IRS's Applicable Federal Rate (AFR) for the month of sale. If the stated rate is below the AFR, the IRS imputes additional interest income to you under the original issue discount (OID) rules. The AFR is published monthly by the IRS and varies by loan term (short, mid, long).
Frequently asked questions
Can I use the installment method if I need cash now?
You can elect out of the installment method by reporting the full gain in the year of sale on your tax return, even if you haven't received all the proceeds yet. Once you elect out, it's irrevocable.
What happens if the buyer defaults?
A default is generally treated as a repossession. You would recognize any gain or loss depending on the FMV of the property at repossession versus the installment sale basis. See IRS Publication 537.
How do I report an installment sale?
Use Form 6252 each year you receive payments to calculate the gain. Report the taxable portion on Schedule D (capital gain) and as ordinary income (recapture and interest).
Sources
- IRS Topic No. 409 — Capital Gains and Losses
- IRS Publication 544 — Sales and Other Dispositions of Assets
- IRS Publication 946 — How to Depreciate Property
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.