Seller Financing Tax Rules for the Seller

The installment method

IRS Publication 537 defines an installment sale as a sale of property where you receive at least one payment after the tax year of the sale. A seller-financed sale nearly always qualifies, and the installment method applies unless you elect out of it. Each payment you receive usually has three parts: interest, a tax-free return of your basis, and gain.

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Selling price less selling expenses and your adjusted basis

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Selling price less debts the buyer assumes (plus any excess of those debts over your basis)

The gross profit percentage generally stays the same for every payment, including the down payment. Interest is separate: it is ordinary income in the year you receive it, not part of the gain.

A worked example

A seller sells a rental for $350,000, with $35,000 down and the rest on a 7% note amortized over 30 years with a balloon after 5 years. Selling costs are $21,000, and the adjusted basis is $220,000: $260,000 of cost less $40,000 of depreciation. The gross profit is $109,000.00, and with no mortgage for the buyer to assume the contract price is the full $350,000, so the gross profit percentage is 31.14%.

Most of the gain arrives with the balloon in year 5, when $296,514.70 of principal is paid. The seller financing calculator produces the payment schedule for your note; apply your own gross profit percentage to each year's principal. Treat this as a sketch of the method: the actual figures come from Form 6252.

Depreciation on a rental: what is reported when

Two different things are sometimes both called depreciation recapture. The first is recapture income: the gain treated as ordinary income under section 1245 or 1250. Under IRC § 453(i) it is recognized in full in the year of sale, whether or not you receive a payment that year, and only the gain above it goes on the installment method; Publication 537 says the same. For a rental, section 1245 recapture comes from personal property such as appliances and furnishings, including components separated out in a cost segregation study or claimed with bonus depreciation. Section 1250 recapture on the building itself is limited to additional depreciation, taken beyond the straight-line method, so a residential rental building depreciated only with the straight-line tables and held more than a year has none.

The second is unrecaptured section 1250 gain: the part of the gain from straight-line depreciation, taxed at up to 25%. On an installment sale it stays on the installment method and is taken into account before the rest of the gain, Treas. Reg. § 1.453-12; the Schedule D instructions apply this payment by payment until all of it has been reported. In the example, the first $40,000.00 of gain reported is taxed that way. The rental property capital gains tax calculator shows the tax on the whole gain if you report it all at once.

Interest and the AFR minimum

The note must charge adequate interest: at least the applicable federal rate the IRS publishes each month for the note's term (short-term for three years or less, mid-term up to nine years, long-term beyond that). If it charges less, part of the principal is treated as interest for tax purposes, called unstated interest. The seller then reports more ordinary interest income and less gain, even though the payments are the same. For October 2026, the AFRs with monthly compounding are 4.17%, 4.52% and 5.1%.

Other rules that change the result

• Electing out. You can choose not to use the installment method. You then report the entire gain in the year of sale, even though you haven't received the money; that can make sense in a year with unusually low income or offsetting losses.
• Dealers. Real property held for sale to customers in the ordinary course of a trade or business isn't eligible for installment sale treatment, so a builder or flipper selling inventory on a note reports the gain up front.
• Sales to relatives. If you sell to a related person who resells the property before you have been paid in full, you may have to treat their sale proceeds as received by you.
• Your home. If the property was your home, the gain you can exclude comes off the gross profit first.

Reporting, pledging and repossession

Form 6252 every year. The installment sale is reported on Form 6252 in the year of sale and in each later year of the agreement, including the year of the final payment, even if no payment arrived that year. Interest goes on your return as interest income, and the gain flows from Form 6252 to Schedule D or Form 4797.

Borrowing against the note. Under the pledge rule, if you use the installment note to secure a loan, the net loan proceeds may be treated as a payment on the note, so part of the deferred gain becomes taxable at that point, up to a limit Publication 537 explains.

If the buyer stops paying. When a seller repossesses real property to protect the security interest in the original note, special rules apply. The gain on repossession is the payments received less the gain already reported, and the taxable gain is limited to the gross profit you originally expected on the sale, less the gain already reported and your repossession costs. The rules have conditions, such as not paying the buyer extra to get the property back unless the contract provided for it or the buyer has defaulted, so read Publication 537 or ask a tax professional before you repossess.

Because each of these events changes the year the gain is taxed, keep the closing statement, the note and a record of every payment received, split between interest and principal, for as long as the note is outstanding.