Installment Sales for Real Estate: Spreading Out Tax Payments

If you sell real estate and the buyer pays you over more than one tax year, the installment method lets you report the gain as the payments arrive instead of all in the year of sale. A fixed share of each principal payment, called the gross profit percentage, is taxable gain, reported on Form 6252, and the rest is a tax-free return of your basis (cost plus improvements, minus depreciation). Two amounts are not spread this way: depreciation recapture taxed as ordinary income is reported in full in the year of sale, and interest on the note is ordinary income in each year you receive it.

Who can use the installment method

An installment sale is any sale, such as a seller-financed sale, where you receive at least one payment after the tax year of the sale. The method applies automatically unless you elect out, but it is not available for:

• A sale at a loss.
• Real estate you hold for sale to customers, such as houses you renovate and resell as a dealer. How flippers are taxed explains when the IRS treats you as a dealer.
• Depreciable property sold to a corporation or partnership you control, unless you show the IRS that avoiding tax was not a main purpose.

A 1031 exchange is the alternative if you want to reinvest in other investment real estate and postpone all of the gain.

How to figure the gross profit percentage

Form 6252 uses these four steps:

1. Installment sale basis: your adjusted basis, plus selling expenses such as commissions, plus any ordinary-income depreciation recapture.
2. Gross profit: the selling price, not counting interest, minus the installment sale basis. This is the total gain you will report.
3. Contract price: the selling price minus any mortgage the buyer takes over. If you own the property free and clear, or the down payment pays off your loan at closing, it equals the selling price. If the mortgage the buyer takes over is larger than your installment sale basis, add the excess back to the contract price; the excess also counts as a payment in the year of sale, and your gross profit percentage becomes 100%.
4. Gross profit percentage: gross profit divided by contract price. Multiply it by the principal you receive each year, including the down payment.

Example. In 2026 you sell a rental house for $400,000. You paid $250,000 for it, claimed $60,000 of depreciation, and pay $22,000 in commissions and closing costs. The buyer pays $80,000 at closing and signs a $320,000 note at 5.25% interest that repays $40,000 of principal each year from 2027 through 2034. You own the house free and clear, and the sale includes no appliances or furniture.

• Installment sale basis: $250,000 minus $60,000, plus $22,000 = $212,000
• Gross profit: $400,000 minus $212,000 = $188,000
• Gross profit percentage: $188,000 divided by the $400,000 contract price = 47%

If the buyer pays off the note early, 47% of the extra principal is gain in the year you receive it.

Which recapture is taxed in the year of sale

• Ordinary-income recapture is reported in full in the year of sale, even if no payment arrives that year. For a rental, this is mainly recapture on appliances, carpet, furniture, and building parts that a cost segregation study reclassified as personal property. It is figured on Form 4797 and added to your installment sale basis, so it is not taxed twice. A residential building placed in service after 1986 and depreciated on a straight line generally has no ordinary-income recapture of its own.
• Unrecaptured section 1250 gain is spread with the payments, but it comes first. This is the part of the gain equal to the building's depreciation, or the whole gain if that is smaller, taxed at your ordinary rate but no more than 25%. The Schedule D instructions treat each year's installment gain as this kind of gain until all of it has been reported.

In the example, the $60,000 of building depreciation is reported first: all $37,600 of the 2026 gain, all $18,800 in 2027, and $3,600 in 2028. The other $15,200 in 2028 and all later gain are taxed at the 0%, 15%, or 20% long-term rates. Depreciation recapture explains both kinds, and capital gains tax on investment property has the 2026 rate thresholds.

The minimum interest rate on the note

If the note's stated rate is below the IRS test rate, part of each principal payment is treated as interest, which shrinks your gain and adds the same amount to interest income taxed at ordinary rates.

The test rate is the lowest applicable federal rate (AFR) in effect during the 3 months ending with the month you sign a binding written contract, or during the 3 months ending with the month of the sale if that is lower. Which AFR applies depends on the note's weighted average maturity, the average time until principal is repaid:

A rate at least equal to the AFR for the month you sign always passes, since the test rate cannot be higher. The example note repays equal principal over 8 years, so its weighted average maturity is 4.5 years, and its 5.25% rate is above the 5.08% mid-term rate for a November 2026 contract.

Reporting the sale each year

1. In the year of sale, complete the first two parts of Form 6252 and carry a rental's gain to Form 4797. Use the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions for the depreciation part.
2. File Form 6252 again every later year through the year of the final payment, even a year with no payment. The gross profit percentage stays the same.
3. If you sold to a related person, also complete Part III for the year of sale and the 2 years after.
4. Report the interest as interest income on your return, not on Form 6252.

To report the whole gain in the year of sale instead, elect out by reporting the sale on Form 4797 or Form 8949 rather than Form 6252, on a return filed by its due date, including extensions. Revoking that election requires IRS approval.

Spreading the gain can keep you under the 3.8% net investment income tax, which applies once modified adjusted gross income (MAGI, usually your adjusted gross income) passes $200,000 for single filers or $250,000 for joint filers. In the example, a married couple with $180,000 of other MAGI would owe $4,484 of that tax (3.8% of $118,000) if they reported all $188,000 in 2026. On the installment schedule their MAGI is $217,600 in 2026 and $215,600 in 2027, including $16,800 of interest, so they owe none if their other income stays the same. Tax planning strategies for rental property income covers other ways to time income around a sale.

Events that end the deferral early

• Selling, giving away, or canceling the note. You report what you receive for it, or its fair market value for a gift or cancellation, minus your basis in the note: the unpaid balance times 100% minus the gross profit percentage.
• Borrowing against the note. For a sale price over $150,000, loan proceeds secured by the note count as a payment on it.
• A related buyer reselling. If you sell to a spouse, child, grandchild, parent, sibling, or related entity that disposes of the property within 2 years and before paying you in full, you are treated as receiving what they realize, up to your contract price, minus the payments you have already received. Later payments are not taxed again until they exceed that amount.

Your death does not end the deferral; whoever inherits the note reports the payments as you would have.

If the buyer defaults and you take the property back

Taking the property back to protect your security interest largely reverses the sale: payments you collected become taxable, and the property returns at about your old basis.

1. Gain on repossession: total payments received before the repossession, minus the gain you already reported.
2. Limit: no more than your original gross profit, minus the gain already reported, minus repossession costs such as legal, court, and recording fees.
3. Basis in the property: your basis in the note (the unpaid balance times 100% minus the gross profit percentage), plus the gain on repossession, plus repossession costs.

The gain is taxed the same way as the original sale's gain, and you cannot deduct the unpaid balance as a bad debt. Suppose the buyer in the example pays through 2028, defaults in 2029, and you spend $9,000 to take the house back:

• Payments received: $80,000 plus $40,000 plus $40,000 = $160,000
• Gain already reported: $37,600 plus $18,800 plus $18,800 = $75,200
• Gain on repossession: $160,000 minus $75,200 = $84,800, under the $103,800 limit ($188,000 minus $75,200 minus $9,000), so you report $84,800 for 2029
• Basis in the house: the $240,000 unpaid balance times 53% = $127,200, plus $84,800, plus $9,000 = $221,000