Real Estate Tax Calc
What a contract for deed is — and how it differs from a traditional sale
A contract for deed — also called a land contract, installment land contract, or bond for deed — is a form of seller financing in which the seller agrees to convey title to the buyer only after the buyer has completed all required payments. Unlike a traditional sale where the deed transfers at closing and the buyer simultaneously obtains a mortgage from a lender, the contract for deed keeps legal title in the seller's name throughout the payment period. The buyer receives equitable title and possession immediately but does not hold the recorded deed until the final payment clears.
From a practical standpoint this arrangement gives the seller security: if the buyer stops paying, the seller does not need to go through a full judicial foreclosure in many states. Instead, state law often allows a faster forfeiture proceeding that cancels the buyer's equitable interest. This speed advantage for sellers is one reason contracts for deed remain popular in certain markets and states, particularly for properties that might not qualify for conventional bank financing.
From a tax standpoint, the structure matters far less than the economic substance. Whether the deed transfers at closing or years later, the IRS analyzes the transaction as an installment sale the moment the seller agrees to receive at least one payment in a future tax year.
Installment sale mechanics under IRC §453
The core concept of installment sale reporting is the gross profit percentage (GPP), also called the gross profit ratio. This percentage tells you what fraction of each principal payment represents taxable gain.
Gross profit = selling price minus adjusted basis (cost plus improvements minus accumulated depreciation).
Contract price = the total amount the buyer will pay, which generally equals the selling price unless the buyer assumes a mortgage or other liabilities.
Gross profit percentage = Gross profit ÷ Contract price.
Each year, the seller reports: Principal payments received that year × GPP = Gain recognized that year.
Interest payments received are not included in the installment sale calculation — they are reported as ordinary income separately, on Schedule B for individuals.
The installment method is automatic for qualifying transactions. If you want to report all the gain in the year of sale instead — perhaps because you have capital loss carryforwards to absorb it — you can elect out of the installment method on a timely filed return.
Depreciation recapture and its interaction with the installment method
Depreciation recapture follows different rules than the rest of the gain, and understanding the distinction is critical for sellers of rental property.
Section 1245 recapture (personal property and certain real property): If the property has §1245 depreciation — common when a cost segregation study was used to reclassify components as 5-year or 7-year property — that recapture amount must be reported as ordinary income in the year of the sale regardless of how much cash you actually received. IRC §453(i)(1) overrides the installment method for §1245 recapture. The contract price is adjusted upward by the §1245 amount for GPP purposes, so the remaining gain is spread over future payments.
Unrecaptured Section 1250 gain (real property depreciated under straight-line MACRS): For residential rental property depreciated at 27.5 years straight-line, there is no §1245 recapture. Instead, the accumulated straight-line depreciation creates unrecaptured §1250 gain, taxed at a maximum federal rate of 25% (rather than the 0%/15%/20% rates that apply to other long-term capital gains). This gain is not accelerated by §453(i) — it flows through the installment method proportionally. Each year's recognized gain carries the same ratio of unrecaptured §1250 to total gain as the overall transaction.
Worked numeric example
A landlord sells a residential rental house on a contract for deed. The facts:
- Selling price: $280,000
- Adjusted basis: $140,000 (original cost $185,000, minus $45,000 accumulated depreciation)
- Accumulated §1250 depreciation (straight-line, residential rental): $45,000
- Down payment (Year 1 principal): $28,000
- Seller-financed balance: $252,000 at 7% interest over 20 years
- No §1245 cost-segregation components; no mortgage assumed by buyer
Step 1 — Compute gross profit and GPP:
Gross profit = $280,000 − $140,000 = $140,000
Contract price = $280,000 (no mortgage assumed)
GPP = $140,000 ÷ $280,000 = 50%
Step 2 — Identify the character of gain:
Unrecaptured §1250 gain = $45,000 (taxed at max 25%)
§1231 gain beyond recapture = $140,000 − $45,000 = $95,000 (taxed at LTCG rates)
Step 3 — Year 1 reporting:
Down payment principal received: $28,000
Gain recognized: $28,000 × 50% = $14,000
Character of Year 1 gain (pro-rated by overall ratio):
Unrecaptured §1250 portion: $14,000 × ($45,000 ÷ $140,000) = $14,000 × 32.14% ≈ $4,500 (taxed at ≤25%)
§1231 capital gain portion: $14,000 − $4,500 = $9,500 (taxed at LTCG rates)
Year 1 interest income (approximate, first full year on $252,000 balance): $252,000 × 7% ≈ $17,640 ordinary income, reported on Schedule B
Total Year 1 taxable income from this sale: $14,000 (installment gain) + $17,640 (interest) = $31,640, broken into three buckets: ordinary interest, §1250 gain, §1231 gain.
The seller files Form 6252 each year to compute the installment income, attaching it to Schedule D. When the balance is eventually paid off or the obligation is sold, the remaining unreported gain is recognized.
Interest income: stated rate vs. imputed interest
All interest received on a contract for deed is ordinary income. The seller reports it on Schedule B in the year received. If the contract uses an amortization schedule, the split between principal and interest is determined by the schedule itself.
The complication arises when the seller charges below-market interest — or no interest at all. Under IRC §1274 (for contracts above a threshold amount) and IRC §483 (for smaller contracts), the IRS imputes interest at the applicable federal rate (AFR) published monthly by the IRS. Imputed interest recharacterizes part of what the parties call "principal" into interest income for the seller (and potentially a deductible expense for the buyer). This reduces the installment gain recognized — because the principal collected is effectively lower — while increasing the seller's ordinary income. The practical effect: sellers charging sub-AFR rates end up with more ordinary income and less capital gain, usually a worse outcome.
Always check the current AFR when structuring a seller-financed contract for deed. Charging at least the AFR avoids imputation entirely. The IRS publishes AFR tables in a revenue ruling each month.
Default and repossession
One of the defining features of a contract for deed is what happens on default. Because legal title never left the seller, many states allow the seller to terminate the buyer's interest through a forfeiture clause — a faster and cheaper process than mortgage foreclosure. After proper notice and cure periods, the seller retakes possession and the buyer loses all payments made. The speed of forfeiture is a key reason sellers favor contracts for deed over purchase-money mortgages in certain states.
The tax consequences of repossession are governed by IRC §1038. When a seller repossesses real property, any gain recognized on repossession is limited to the lesser of (1) the gain already deferred under the installment method, minus payments already received above the original basis, or (2) the money and fair market value of property received in prior years, minus gain already reported. In plain terms, §1038 generally limits the repossession gain and allows the seller to take back the property with a stepped-up basis equal to the buyer's payments plus the original adjusted basis. Losses on repossession are not recognized immediately.
The seller also stops reporting installment income once possession is regained and re-enters the property on the books at its repossession-date basis.
Contract for deed vs. traditional installment note: key differences
Both structures produce installment sale tax treatment, but they differ in legal mechanics. Under a traditional sale with a purchase-money note (seller takes back a mortgage or deed of trust), the deed transfers at closing and the seller holds a lien against the property. If the buyer defaults, the seller must foreclose, which can take months or years depending on the state.
Under a contract for deed, the seller retains the legal title throughout — which speeds up repossession in forfeiture states but can also create complications. Some lenders will not make loans to buyers under contracts for deed because there is no recorded mortgage to secure against. Additionally, if the seller has an existing mortgage with a due-on-sale clause, transferring equitable title via a contract for deed can technically trigger that clause.
From a pure tax standpoint, both structures produce the same Form 6252 mechanics. The legal differences — title retention, forfeiture vs. foreclosure, lender approval — are real estate law questions that vary significantly by state and should be reviewed with a local real estate attorney before closing.
Reporting on Form 6252 year by year
The seller files Form 6252 (Installment Sale Income) for the year of sale and each subsequent year in which a payment is received. The form walks through:
- The gross selling price, adjusted basis, and gross profit (Part I).
- The contract price and gross profit percentage (Part I).
- Payments received in the current year (principal only, not interest) and the resulting gain (Part II).
- Ordinary income from §1245 recapture if any (Part II).
The recognized installment gain flows to Schedule D (for capital gain) or Form 4797 (for §1231 property). Interest income goes directly to Schedule B. Each year the seller must track: total contract price, cumulative principal received, and cumulative gain already reported — all needed to compute future years' returns.
If the seller sells or transfers the installment obligation itself (gifts it, sells it to a third party, or contributes it to a partnership or S corporation), the remaining deferred gain is generally triggered immediately in the year of transfer. This acceleration catches many sellers off guard when estate planning involves an installment note.
Frequently asked questions
What is a contract for deed?
A contract for deed (also called a land contract or installment land contract) is a seller-financed sale where the seller retains legal title until all payments are complete. The buyer gets immediate possession and equitable title but does not receive the recorded deed until the balance is paid in full.
How is gain taxed when selling on contract for deed?
A contract for deed is treated as an installment sale under IRC §453. The seller reports gain gradually as principal payments arrive. Each year's taxable gain equals the gross profit percentage (total gain ÷ contract price) multiplied by the principal collected. Interest collected is ordinary income reported separately on Schedule B.
Can I do a 1031 exchange on a contract for deed sale?
Yes, but it requires careful advance structuring. The installment obligation generally constitutes boot unless a qualified intermediary holds the note as part of the exchange. The exchange must be established before the closing, not after. Work with a qualified intermediary and tax advisor before the sale closes to preserve the deferral.
What happens if the buyer defaults on a contract for deed?
If the buyer defaults and the seller repossesses the property, IRC §1038 limits the gain recognized on repossession. The seller generally takes the property back with a basis equal to the buyer's payments made plus the seller's original adjusted basis at the time of sale. Forfeiture laws vary by state and can make repossession faster than mortgage foreclosure.
What if the interest rate on a contract for deed is too low?
If the stated rate is below the IRS applicable federal rate (AFR), IRC §1274 or §483 imputes interest at the AFR. This recharacterizes part of each payment from principal (capital gain) to ordinary interest income. The result is higher ordinary income and lower capital gain than the parties intended. Charge at least the current AFR to avoid imputation.
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.