Installment Sales for Real Estate: Spread Your Tax Bill

Selling investment property can trigger a massive tax bill—sometimes hundreds of thousands of dollars all at once. But what if you could spread that tax burden over several years, keeping more cash in your pocket and maintaining flexibility with your income? That's exactly what an installment sale offers.

An installment sale allows you to receive payments for your property over time rather than in a lump sum, which means you only pay capital gains taxes as you receive the money. This powerful tax strategy can help real estate investors manage their tax liability, stay in lower tax brackets, and maintain liquidity.

What Is an Installment Sale?

An installment sale is a transaction where the seller finances the purchase and receives at least one payment after the tax year of the sale. Instead of receiving the full purchase price upfront, you receive payments over multiple years, and you only pay taxes on the profit portion of each payment as it's received.

For example, if you sell a rental property for $500,000 with a $100,000 gain and structure it as a five-year installment sale, you'd potentially spread that $100,000 taxable gain over five years instead of recognizing it all at once.

How Installment Sales Work

The mechanics of an installment sale are straightforward but require careful documentation:

The Basic Structure: You sell your property and provide [seller financing](/blog/seller-financing-guide) to the buyer. The buyer makes regular payments to you (typically monthly) that include both [principal and interest](/blog/amortization-schedule-guide). Each payment you receive contains three components: return of basis (not taxable), capital gain (taxable), and interest income (taxable as ordinary income).

Gross Profit Percentage: The IRS uses a "gross profit percentage" to determine how much of each payment is taxable gain. This is calculated by dividing your gross profit by the contract price. For instance, if you have a $200,000 gain on a $500,000 sale price, your gross profit percentage is 40%. This means 40% of each principal payment is taxable as capital gain.

Interest Requirements: The IRS requires you to charge adequate interest on installment sales. As of 2026, the Applicable Federal Rate (AFR) sets the minimum interest rate you must charge. If you charge below this rate, the IRS will impute interest, which could create unfavorable tax consequences.

Tax Benefits of Installment Sales

The installment sale method offers several compelling tax advantages:

Spread Capital Gains Over Multiple Years: Instead of taking a massive tax hit in one year, you recognize gains gradually. This can be particularly beneficial if you're facing a year with already-high income.

Stay in Lower Tax Brackets: By spreading income over several years, you may avoid pushing yourself into higher capital gains tax brackets. For 2026, the difference between the 15% and 20% capital gains rate can be substantial.

Defer Tax Payments: You defer paying taxes until you actually receive the cash, improving your cash flow and potentially earning returns on money that would otherwise go to taxes.

Net Investment Income Tax Management: High earners pay an additional 3.8% Net Investment Income Tax on capital gains. Spreading gains over multiple years might keep your modified adjusted gross income below the threshold ($200,000 for single filers, $250,000 for married filing jointly).

Qualifying for Installment Sale Treatment

Not every property sale qualifies for installment sale treatment:

Eligible Properties: Most real estate investments qualify, including rental properties, land, commercial buildings, and vacation rentals. Your primary residence can use installment sale treatment, but you'll first apply the [capital gains exclusion](/blog/home-sale-exclusion-guide) ($250,000 single, $500,000 married).

Ineligible Properties: Dealer property (real estate held primarily for sale to customers) doesn't qualify. If you're a real estate developer or flipper, the IRS may consider your inventory as dealer property subject to ordinary income tax, not eligible for installment treatment.

Depreciation Recapture: Here's a critical detail many investors miss—depreciation recapture must be recognized in the year of sale, even with an installment sale. If you've claimed $50,000 in depreciation deductions over the years, that amount is taxed as ordinary income (up to 25%) in the sale year, regardless of payment structure.

Setting Up an Installment Sale

Properly structuring an installment sale requires careful planning:

Written Agreement: Create a detailed promissory note and purchase agreement outlining payment terms, interest rate, payment schedule, and default provisions. This isn't optional—it's essential for IRS compliance and legal protection.

Adequate Security: Secure your position with a mortgage or deed of trust on the property. If the buyer defaults, you want the ability to foreclose and reclaim the property.

Down Payment Considerations: While there's no minimum down payment requirement for installment sale treatment, practical lending standards suggest 10-20%. A larger down payment reduces your risk and demonstrates buyer commitment.

Interest Rate: Charge at least the AFR published monthly by the IRS. Rates vary based on the term of the loan (short-term, mid-term, or long-term). Check IRS.gov for current rates.

Balloon Payments: Many installment sales include a balloon payment after 5-10 years. This gives you steady income while allowing the buyer to refinance with traditional financing later.

Calculating Your Tax Liability

Understanding the tax calculation helps you project future obligations:

Step 1: Determine Gross Profit

• Selling price: $600,000
• Adjusted basis: $400,000
• Gross profit: $200,000

Step 2: Calculate Gross Profit Percentage

• Gross profit ($200,000) ÷ Contract price ($600,000) = 33.33%

Step 3: Apply to Each Payment

• If you receive $120,000 in principal payments in year one
• Taxable gain: $120,000 × 33.33% = $40,000
• This $40,000 is taxed at capital gains rates

Step 4: Add Interest Income

• If you collect $24,000 in interest
• This is taxed as ordinary income at your marginal rate

Risks and Drawbacks to Consider

Installment sales aren't without challenges:

Buyer Default Risk: Your biggest risk is the buyer stopping payments. While you can foreclose, this involves time, expense, and potentially receiving back a property worth less than when you sold it.

Locked-In Asset: Your proceeds are tied up in the installment note rather than being available for other investments. You're essentially betting that the return (interest rate) plus tax deferral benefits outweigh other investment opportunities.

Tax Law Changes: Future tax law changes could affect your benefits. If capital gains rates drop, you might regret deferring income. Conversely, if rates rise, your strategy looks brilliant.

Phantom Income Risk: If the buyer defaults and you foreclose, you've already paid taxes on payments received, but you're back holding the property. You'll need to account for this in future sale calculations.

Death Before Collection: If you die with an outstanding installment note, your heirs inherit the obligation to pay taxes on future payments but may not receive basis step-up on the note. Estate planning is essential.

Installment Sale vs. 1031 Exchange

Both strategies defer taxes, but they work differently:

1031 Exchange allows complete tax deferral if you reinvest all proceeds in like-kind property. You must identify replacement property within 45 days and close within 180 days. Your capital stays invested in real estate.

Installment Sale spreads taxes over time but doesn't require reinvestment. You have flexibility with the proceeds and can diversify out of real estate. The tax is deferred, not eliminated.

Which Is Better? If you want to stay in real estate and have identified suitable replacement property, a 1031 exchange typically offers greater tax benefits. If you want to exit real estate, need income, or can't find suitable replacement property, an installment sale provides valuable tax management.

Reporting Installment Sales

Proper tax reporting is crucial:

Form 6252: File "Installment Sale Income" with your tax return each year you receive payments. This form calculates the taxable portion of payments received.

First Year Details: In the sale year, provide complete transaction details including selling price, basis, gross profit, and payment terms.

Subsequent Years: Report payments received, calculate the taxable portion, and carry forward the remaining deferred gain.

Interest Income: Report interest separately on Schedule B as ordinary income.

State Taxes: Don't forget state tax implications. Most states follow federal installment sale rules, but verify your state's specific requirements.

Advanced Strategies

Sophisticated investors combine installment sales with other techniques:

Partial 1031 Exchange: You can do a partial 1031 exchange on some proceeds while using installment sale treatment on the remainder. This requires careful coordination with a [qualified intermediary](/blog/1031-exchange-rules-2026).

Charitable Installment Sale: Donate a portion of the property to charity before the sale, reducing your taxable gain while supporting a cause you care about.

Installment Sale to Intentionally Defective Grantor Trust (IDGT): This advanced estate planning technique allows you to sell property to a trust, freeze your estate value, and spread tax recognition—but requires expert legal and tax guidance.

Self-Canceling Installment Note (SCIN): The note automatically cancels upon your death, removing it from your estate but requiring careful actuarial calculations.

When Installment Sales Make the Most Sense

Consider an installment sale if you:

• Face a large capital gain that would push you into a higher tax bracket
• Don't need all proceeds immediately and want steady income
• Can't identify suitable 1031 exchange replacement property
• Want to help a buyer who can't obtain traditional financing
• Are selling to family members at favorable terms
• Need to manage Modified Adjusted Gross Income (MAGI) for ACA subsidies, Medicare premiums, or other income-tested benefits

Common Mistakes to Avoid

Inadequate Documentation: Verbal agreements and informal notes won't hold up under IRS scrutiny. Use proper legal documentation.

Below-Market Interest Rates: Charging interest below the AFR triggers imputed interest rules that create unfavorable tax consequences.

Ignoring Depreciation Recapture: Forgetting that depreciation recapture is taxed in year one, regardless of payment structure, leads to unexpected tax bills.

No Security Interest: Failing to secure the note with a mortgage or deed of trust leaves you vulnerable if the buyer defaults.

Mixing Business and Personal: If you're selling to family or friends, maintain professional documentation and arm's-length terms to withstand IRS challenge.

Working with Professionals

Installment sales involve complex tax and legal considerations:

Tax Advisor: A CPA experienced in real estate taxation can model different scenarios, calculate tax impact, and ensure proper reporting.

[Real Estate Attorney](/blog/how-to-build-real-estate-team): Draft proper documentation including promissory notes, mortgages, and purchase agreements that comply with state law.

Financial Planner: Help you evaluate whether installment sale terms make sense compared to alternative investment strategies.

Qualified Intermediary: If combining with a partial 1031 exchange, you'll need a QI to handle the mechanics.

Frequently Asked Questions

Q: Can I sell the installment note to a third party? A: Yes, but selling the note typically triggers immediate recognition of all remaining deferred gain. This is called a "disposition of an installment obligation" and generally defeats the tax deferral benefit.

Q: What happens if the buyer pays off the note early? A: You'll recognize all remaining deferred gain in the year of payoff. Consider including a [prepayment penalty](/blog/dscr-loan-prepayment-penalty) to compensate for accelerated tax liability.

Q: Can I use an installment sale for my primary residence? A: Yes, but you'll first apply the $250,000/$500,000 capital gains exclusion. Installment treatment applies to any gain exceeding the exclusion.

Q: Do I need to charge the same interest rate as a bank? A: No, you only need to charge at least the Applicable Federal Rate (AFR), which is typically below market rates. However, charging market rates makes your note more valuable and marketable.

Q: What if the buyer wants to assume my existing mortgage? A: This creates a "deemed payment" equal to the mortgage assumed, which could trigger immediate tax on a portion of your gain. Careful structuring is essential.

Q: Can I do an installment sale to a family member? A: Yes, but special rules apply. If they resell within two years, you may have to recognize all deferred gain immediately. Use arm's-length terms and proper documentation.

Q: How does an installment sale affect my Medicare premiums? A: Since Medicare Part B and D premiums are based on modified adjusted gross income from two years prior, spreading gain over multiple years can help avoid or reduce Income-Related Monthly Adjustment Amounts (IRMAA).

Q: What happens to the installment note when I die? A: The note becomes part of your estate. Your beneficiaries inherit the obligation to pay taxes on future payments but don't receive basis step-up on the note itself. Proper estate planning is crucial.

slug: "installment-sale-real-estate"

Installment sales represent a powerful tool for managing real estate capital gains taxes. By spreading tax liability over several years, you maintain flexibility, manage tax brackets, and improve cash flow. However, these benefits come with complexity and risk that require careful evaluation and professional guidance.

Before committing to an installment sale, run the numbers, understand the mechanics, assess the buyer's creditworthiness, and consult with qualified tax and legal professionals. When properly executed, an installment sale can save you tens or hundreds of thousands in taxes while providing steady income for years to come.

Related Articles

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• 1031 Exchange: Defer Taxes, Build Wealth Faster
• [[Rental [Property Depreciation](/blog/rental-property-tax-deductions)](/blog/depreciation-real-estate-guide) Guide: How to Maximize Your Tax Deductions in 2026](/blog/depreciation-rental-property-guide)