Installment sale
If you sell on installments (collecting principal over multiple years), you only pay capital-gains tax on the principal you receive each year. The structure is governed by IRC Section 453 and is the tax mechanism that makes seller financing attractive for long-held appreciated property.
The installment sale is the tax treatment that makes seller financing financially attractive for many sellers. It's defined in IRS Code Section 453 and applies whenever a sale of real estate (or other capital asset) involves at least one principal payment received in a year after the year of sale.
How it works
In a normal cash sale, you recognize the entire capital gain in the year of sale and pay tax on it that year. If you sell a $2.4 million property with a $400K basis, you have a $2 million gain to recognize, all in year one.
In an installment sale, you recognize a portion of the gain each year, in proportion to the principal received that year. The formula:
Gross profit ratio = total gain / total contract price
Each year, the principal received is multiplied by the gross profit ratio to determine that year's recognized gain.
A worked example
Same $2.4M sale, $400K basis, $2M gain. Now structured as 25% down ($600K) plus a 5-year owner-carry note for $1.8M at 7% interest.
Gross profit ratio = $2M gain / $2.4M = 83.3%.
In year one, you receive $600K of principal. Gain recognized: $600K × 83.3% = $500K.
In years two through five, you receive principal as the note amortizes (plus interest, which is taxed separately as ordinary income). Each year's principal × 83.3% determines the gain recognized that year.
By year five, you've recognized the same $2M gain, but spread over five years instead of compressed into one. At long-term capital-gains rates, the federal tax bill is roughly the same in total, but the year-by-year exposure is much lower, which often keeps you in lower brackets and avoids spike-year surcharges (NIIT, AMT).
Important caveats
Several points where installment sale rules get complicated:
- Depreciation recapture is NOT spread. Section 1250 recapture (the depreciation you've claimed) is recognized in full in the year of sale, not spread. Your CPA needs to model this separately.
- Related-party rules. Selling to a related party triggers different treatment.
- Pledged note proceeds. If you borrow against the note, the loan proceeds can trigger gain recognition.
- Election out. You can elect out of installment treatment if it's not advantageous (rare, but possible).
This is not tax advice. Consult your CPA before structuring anything. The installment-sale mechanics are well-established but the application to a specific seller's situation requires a professional review.
How this connects to Kallpa
When we structure a seller-financed deal, you and your CPA decide whether installment-sale treatment makes sense for your tax situation. We don't push the structure either way. We explain the trade-offs and we structure the note documentation so your tax position is preserved.
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