Installment Sales
Installment Sales
An installment sale allows a property owner to sell real estate and receive payment over multiple years rather than in a lump sum, spreading the capital gains tax burden across those years while earning interest on the deferred payments.
Key takeaways
- Spread capital gains recognition across years; recognize gain only as payments are received, not on the sale date
- Use installment sales to manage Modified Adjusted Gross Income (MAGI) and stay below income-based thresholds (net investment income tax, Medicare premium increases, passive loss phase-outs)
- The IRS imposes minimum interest rates (the Applicable Federal Rate, or AFR) on seller financing; ignore this and the IRS will impute interest
- Installment sales work well for owner-financed sales; coordination with bank financing is more complex
- Plan for recapture tax: depreciation claimed on the property is recaptured in full, even if gains are spread
The mechanics: deferring gain recognition across payment years
An installment sale is a sale where you receive at least one payment after the tax year of sale. The simplest case is owner financing: you sell the property to a buyer who makes a down payment and signs a promissory note for the remainder, payable over years.
Your gain is the sales price minus your adjusted basis. The installment method allows you to recognize that gain ratably as payments are received.
Example: you sell a property with a $300,000 basis for $1 million. Your total gain is $700,000. The buyer pays $200,000 down and finances the remaining $800,000 over 10 years at 6% interest (let us assume $8,900 per month).
In year one, you receive $200,000 down plus 12 months of $8,900 payments, totaling approximately $306,800. Of that, how much is gain?
Your "gross profit" is $700,000 (gain). Your "total contract price" is $1 million (sale price). Your "profit ratio" is 70% ($700,000 / $1,000,000). Of the $306,800 received in year one, $214,760 is gain ($306,800 × 70%), and the rest is basis recovery.
In year two and beyond, the same ratio applies. Each payment is split: 70% is gain, 30% is basis recovery. By year ten, the entire $700,000 gain has been recognized, stretched across the payment period.
This spreads the tax. If you owe 24% tax on the gain (20% capital gains rate plus 3.8% NIIT, plus state tax), your year-one tax is $51,542 on the $214,760 gain. If you had recognized the full $700,000 gain in year one, your tax would be $168,000—a material difference in cash flow.
The Applicable Federal Rate and imputed interest
The IRS requires that installment notes carry a minimum interest rate, called the Applicable Federal Rate (AFR). As of 2024, the AFR for long-term debt (over nine years) is approximately 3–5%, depending on the month of sale.
If you sell property for $1 million and the buyer finances $800,000 at 0% interest (no stated rate), the IRS will "impute" interest at the AFR. This means:
- The sales price is treated as if it included interest revenue equal to the AFR applied to the deferred payments.
- You owe ordinary income tax on the imputed interest.
- The buyer can deduct the imputed interest (if they are in business).
Imputed interest is not the same as the stated interest on the note. If you charge 6% stated interest, but the AFR is 4%, no imputation occurs. If you charge 2% stated interest, the IRS imputes the additional interest.
This is a trap for informal family sales. If you sell real estate to a family member on a handshake deal with minimal interest, the IRS will impute interest at the AFR, and you will owe ordinary income tax on that phantom interest, even if the buyer does not pay it.
To avoid imputation, charge at least the AFR on any installment note. Work with a tax attorney to document the interest rate clearly in the promissory note.
Coordination with depreciation recapture
As discussed in earlier chapters, depreciation claimed during your ownership is recaptured when you sell. The recapture tax is 25% on the excess depreciation (the depreciation claimed minus what would have been allowed under straight-line) for depreciable real estate.
In an installment sale, recapture is owed in full in the year of sale, not spread across the installment period. If you claimed $200,000 of depreciation and the recapture tax is $50,000 (25% × $200,000), you owe that $50,000 tax in year one of the installment sale, even if you receive only $200,000 of payments that year.
The remaining capital gain is spread across the installment period. So in year one, you owe tax on the full recapture ($50,000) plus a portion of the capital gain. The gain continues to be spread across future years.
This limits the attractiveness of installment sales for heavily depreciated properties. If you have claimed $500,000 in depreciation, the recapture tax bill is immediate and material, offsetting some of the income-spreading benefit.
Installment sales and MAGI management
The strategic value of installment sales often lies in managing Modified Adjusted Gross Income (MAGI). Many tax benefits phase out above MAGI thresholds:
- Net Investment Income Tax (3.8% Medicare tax): applies above $200,000 MAGI for single filers, $250,000 for married.
- Passive Loss Deduction Phase-out: the $25,000 exception phases out above $100,000 MAGI.
- Alternative Minimum Tax (AMT): triggered at higher MAGI levels.
- Roth Conversion Window: converting too much in a given year can trigger "pro-rata" IRA taxation.
By spreading a large gain across multiple years, you can stay below these thresholds. If you have $500,000 of capital gain but usually earn $150,000, a lump-sum sale would create $650,000 MAGI and trigger the 3.8% NIIT on much of the gain. An installment sale spreading the gain over five years keeps MAGI closer to $250,000 (including the installment payments), potentially keeping you below the NIIT threshold for most years.
This is sophisticated tax planning, but it is a legitimate use of installment sales.
Installment sales combined with leverage: the wraparound note
In some cases, a seller uses a "wraparound" or "all-inclusive" note. The buyer receives financing from both the original lender (the underlying mortgage) and the seller (a second note). The buyer makes one payment to the seller, who then pays the underlying mortgage and keeps the difference.
This is complex and carries risks: if the underlying mortgage has a "due-on-sale" clause, the lender can call the note due if the property is sold. Many mortgages do include this clause, which makes wraparound notes impossible.
For real estate investors, wraparound notes are usually avoided. Stick with simple owner-financed sales where the buyer takes a new loan (if any) and the seller receives a straightforward note.
Risk of buyer default and foreclosure
In an installment sale, you are the lender. If the buyer defaults, you must foreclose or pursue other remedies to recover the property. This can be expensive and time-consuming, particularly if the property has declined in value.
To mitigate risk, take a substantial down payment (20–30%), charge interest at fair-market rates to compensate for risk, and document everything in a professional promissory note and mortgage or deed of trust (depending on your state's laws).
In some cases, sellers buy title insurance to protect against title defects and seller fraud insurance to protect against buyer default. The cost is material but may be justified for large sales.
Deciding between installment sales and lump-sum sales
Documentation and IRS reporting: Form 6252
When you elect installment-method reporting, file Form 6252 (Installment Sales Income) with your tax return in the year of sale and each subsequent year you receive payments. The form requires:
- The basis and adjusted basis of the property
- The sales price
- The gross profit
- The total amount of payments in the current year
- The gain to be reported in the current year
For subsequent years, the form is simpler: it just reports the payments received and the gain ratio.
If you use the installment method but fail to file Form 6252, you may be deemed to have elected out of installment reporting, and the entire gain would be recognized in the year of sale. This is catastrophic if you intended to spread the gain. File the form every year you have installment payments.
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