Tax considerations of installment sales: the basics for sellers

What counts as an installment sale

The IRS describes an installment sale as a sale of property where you receive at least one payment after the tax year in which the sale occurs. Seller financing is the most common example in real estate: the buyer pays part of the price at closing and the rest over time under a note.

IRS Publication 537 explains the rules in detail, and IRS Topic No. 705 gives a short summary. Under the installment method, each payment of principal you receive is generally treated as part return of your basis, part gain, and, separately, any interest is interest income. The installment method generally cannot be used to report a loss, and certain sales, such as those by dealers or of inventory, are excluded.

How the gain is spread out

The installment method uses a gross profit percentage. In simple terms, you figure your gross profit on the sale and divide it by the contract price. That percentage of each principal payment you receive in a year is generally reported as gain for that year.

Purely as a hypothetical with round numbers: if the gross profit percentage on a sale worked out to 40 percent, then 40 percent of each principal payment would generally be reported as gain in the year received. Real calculations involve adjusted basis, selling expenses, existing mortgages the buyer takes over, and other details covered in Publication 537.

The sale is reported on Form 6252, Installment Sale Income, in the year of sale and typically in each later year in which you receive a payment. You can also elect out of the installment method and report the entire gain in the year of sale. Whether that is sensible depends on your circumstances.

Rental property and depreciation recapture

If you sell a rental or other property you depreciated, pay close attention here. Publication 537 explains that depreciation recapture income must generally be reported in full in the year of sale, even if you receive little or no cash that year. That can create a tax bill before the payments arrive.

Gain tied to depreciation on real property can also be taxed at different rates from other capital gain. How much of your gain falls into each category depends on the assets involved and the depreciation methods used. Publications 527 and 544 cover rental property and the sale of business assets. A tax professional should work through these numbers before you agree to terms.

Interest income and imputed interest

The interest the buyer pays you is generally reported as ordinary interest income each year, separate from the gain. If the buyer uses the home as a personal residence, the IRS requires additional reporting details about the buyer on your return.

If a note charges no interest or too little, federal tax rules can treat part of each payment as interest anyway. These unstated or imputed interest rules, found in sections 483 and 1274 of the Internal Revenue Code, compare the stated rate with the applicable federal rates the IRS publishes each month. Setting the rate without checking these rules can change how payments are taxed for both you and the buyer.

Other situations that change the picture

Several events can speed up or alter the tax treatment of an installment sale. Publication 537 addresses each of them:

• Selling, giving away, or otherwise disposing of the note before it is paid off
• Using the note as security for a loan in certain circumstances
• Selling to a related person who then resells the property within a set period
• Repossessing the property after the buyer defaults
• Very large installment obligations, which can carry an interest charge on deferred tax

Your main home is a separate question

If you sell your main home, you may qualify to exclude some or all of the gain under the home sale rules, whether or not you finance part of the price. The installment method can apply to any taxable gain that remains. Rules on ownership, use, and periods of rental use can affect the exclusion, so review them with your tax professional.

Putting it in context

Spreading gain over several years may help some sellers and make little difference to others, and it does not change the risk that a buyer stops paying. Weigh the tax picture alongside the financial and legal risks of carrying a note.

Prominent Cash Offer buys houses nationwide for cash in any condition, with no fees or commissions and closing costs paid on cash purchases, a closing date you choose, and a written, no-obligation offer. Flexible arrangements are evaluated case by case, and not every property, seller, or state qualifies. Prominent does not give tax advice and makes no promise about any tax outcome. Please consult a tax professional.