Installment sale of a rental: seller financing taxes

By Tom, CPA · Updated October 27, 2026

Part of: Rental Property Taxes

TL;DR: With an installment sale, you report gain as you collect principal, using a gross profit percentage, and interest is taxed as ordinary income. But ordinary depreciation recapture is taxed in the year of sale no matter what you collect, the note must carry at least the applicable federal rate or interest is imputed, and dealers can't use the method.

Educational only, not tax, legal, or investment advice. Examples are illustrations, not predictions. Rules and limits change; verify current figures and talk to a qualified professional about your situation.

Seller financing is the landlord's retirement fantasy: sell the rental, become the bank, collect a monthly check without fixing anything. The tax version, section 453, lets you spread the gain over the years you collect principal. It's genuinely useful, and it comes with three traps: recapture, interest rules and the buyer who stops paying. This guide covers all three, per IRS Publication 537.

For the full gain calculation, start with selling a rental property.

CPA Warning Label: Recapture is taxed in the year of sale even if all you collected was a small down payment. Size the down payment to cover the tax.

How installment method works

An installment sale is a sale where you receive at least one payment after the tax year of the sale. The installment method applies automatically unless you elect out on a timely filed return.

Each year, you report:

• Interest income, taxed as ordinary income.
• Return of basis, tax-free.
• Gain, equal to principal payments received times the gross profit percentage.

Gross profit percentage = gross profit ÷ contract price. Gross profit is the selling price minus adjusted basis and selling expenses (and minus any recapture already reported). Contract price is generally the selling price minus any existing mortgage the buyer assumes, but if the assumed mortgage exceeds your basis, the excess is treated as a payment in the year of sale.

The down payment is a payment in year one. Report the sale on Form 6252 for the year of sale and every year you receive a payment.

Recapture is taxed upfront

Under section 453(i), any depreciation recapture income under sections 1245 and 1250 is reported in full in the year of sale, even if you receive no cash that year. That's ordinary recapture: gain on appliances, furniture and cost seg personal property, plus any excess-over-straight-line 1250 recapture. Recapture income is then added to basis for figuring the remaining installment gain, so it's not taxed twice.

The 25% unrecaptured section 1250 gain is not 453(i) recapture. It's part of the installment gain, and under the regulations (Treas. Reg. 1.453-12) it's taken into account first, before regular capital gain, as payments arrive. So early payments are taxed at up to 25%, later payments at capital gains rates.

If you did a cost segregation study and took heavy bonus depreciation, 453(i) can create a big ordinary income bill in the year of sale, when you've collected only a down payment. Plan the down payment to cover it.

Interest rate minimums (AFR)

If the note doesn't charge adequate interest, the tax code recharacterizes part of the principal as interest. Under sections 483 and 1274, the minimum is generally the applicable federal rate (AFR) for the note's term, published monthly by the IRS. Lower rates may apply in limited cases (for example, section 1274A caps for certain smaller seller-financed sales). Without adequate stated interest, unstated interest is imputed, which converts part of your capital gain into ordinary interest income and gives the buyer an interest deduction.

Check the AFR table in the month you sign the contract; the IRS publishes short-term (3 years or less), mid-term (over 3 to 9 years) and long-term (over 9 years) rates. Most seller-financed real estate notes charge more than the AFR anyway because the seller wants a market return.

Dealer exclusion and other limits

• Dealers: section 453(b)(2) excludes dealer dispositions of real property (property held for sale to customers). A house flipper's inventory can't use installment reporting. See fix and flip taxes.
• Related-party resales: if you sell to a related person who resells within two years, you may be treated as receiving the resale proceeds (section 453(e)).
• Large notes: under section 453A, if the face amount of installment obligations from sales over $150,000 that you hold at year-end exceeds $5 million, you owe interest on the deferred tax.
• Pledging the note: using the note as collateral for a loan is treated as receiving payment of the loan amount (section 453A(d)).
• Selling the note or gifting it: generally triggers remaining gain (section 453B).

Example

Illustration (made-up numbers): Frugal Fran sells a rental in 2026 for $400,000 with selling costs of $20,000. Adjusted basis is $180,000, after $90,000 of building depreciation and $10,000 of fully depreciated appliances (which sell for $2,000). No mortgage. The buyer pays $80,000 down and signs a $320,000 note at 7% over 15 years.

In 2026 Fran reports $2,000 ordinary recapture, about $45,500 of installment gain (all of it unrecaptured 1250 gain at up to 25%, because that piece goes first), plus interest income. In later years, each principal payment brings 49.5% gain, which shifts from 25% to capital gain rates once the $90,000 of 1250 gain is used up. Spreading $198,000 over 15 years may keep her in the 0% or 15% bracket and below the NIIT threshold in many years, depending on other income.

Compare the all-cash alternative: $200,000 of gain in one year, with $90,000 at up to 25% and $110,000 at 15% or higher, probably over the NIIT threshold for a married couple with other income. The installment version trades that single spike for years of smaller bites, plus 7% interest on money that would otherwise have gone to the IRS in April. The cost is waiting, and trusting the buyer.

When the buyer takes over your mortgage

If the buyer assumes or takes subject to your existing mortgage, the mortgage isn't treated as a payment to you, unless it exceeds your adjusted basis (plus selling costs). The excess is treated as a payment received in the year of sale, and the contract price shrinks by the mortgage amount, which raises the gross profit percentage.

Illustration: Lavish Larry sells for $500,000 with a $300,000 mortgage the buyer assumes and a basis of $200,000 (ignore costs). Mortgage in excess of basis: $100,000, treated as a year-one payment. Contract price: $500,000 − $300,000 + $100,000 = $300,000. Gross profit: $300,000. Gross profit percentage: 100%. Every dollar of principal Larry collects, plus the $100,000 deemed payment, is gain. Highly leveraged, low-basis rentals get less deferral than people expect.

Wraparound mortgages, where your loan stays in place and the buyer pays you a larger note, have their own reporting rules and lender due-on-sale risks; get legal help.

Risks that aren't tax

• Default: if the buyer stops paying, you may foreclose and get the property back. Repossession rules under section 1038 limit gain recognized on repossession of real property, but you'll have legal costs and a property in unknown condition.
• Balloon payments: many seller notes balloon in 5 to 10 years; if the buyer refinances, you get the rest of the gain at once.
• Concentration: your retirement income depends on one borrower. Underwrite them like a bank: credit report, income verification, a meaningful down payment.
• Dodd-Frank and state lending rules can apply to seller financing of owner-occupied homes; investor-to-investor deals are generally simpler. Get legal help drafting the note and mortgage or deed of trust.

Installment sale vs 1031 vs all cash

A 1031 exchange defers everything but keeps you a landlord. An all-cash sale is simple but taxes everything in one year. An installment sale sits in between: you leave real estate, defer capital gain, earn interest, and take credit risk. It pairs well with early retirement, when your ordinary income drops and the 0% capital gains bracket opens up. Compare with the 1031 vs sell calculator.