Selling a Rental on an Installment Note: Tax Each Year

How an installment sale of rental property works

You sell the rental, the buyer pays part of the price at closing, and you carry a note for the rest, secured by a first-position deed of trust or mortgage on the property. Under installment sale tax rules (IRC 453), each principal payment carries the same gross profit percentage of gain, and the interest is ordinary income. For the general mechanics, see seller financing taxes.

A rental is different from raw land because of depreciation. The gain on a rental is taxed in layers, and the installment method moves those layers into a specific order.

The order the gain comes out

1. Recapture income, year one, all of it. IRC 453(i) pulls Section 1245 recapture and Section 1250 additional depreciation into the year of sale, whatever the buyer pays. For most post-1986 buildings depreciated straight line there is no Section 1250 recapture income. But a cost segregation study moves components into 5-, 7- and 15-year property: depreciation on the 5- and 7-year items is Section 1245 recapture, and bonus or accelerated depreciation on 15-year land improvements is Section 1250 additional depreciation. Both are ordinary income in year one.
2. Unrecaptured Section 1250 gain, first out of each payment. Straight-line depreciation on the building creates gain taxed at up to 25%. It is not recapture income, so it spreads. Treas. Reg. 1.453-12 says it is taken into account before the rest of the capital gain.
3. Long-term capital gain, last. Taxed at 0%, 15% or 20% depending on income that year.

So early payments carry the 25% layer, and later payments carry the lower rates. The recapture is added to basis for the installment computation, so it is never taxed twice. More detail: depreciation recapture on an installment sale and 1245 vs 1250 recapture.

The 3.8% tax and suspended passive losses

Net investment income tax

For an owner who is not a real estate professional, gain on a rental and interest on the note are net investment income. The 3.8% tax (IRC 1411) applies to the lesser of that income or modified AGI over $250,000 for joint filers ($200,000 single); those thresholds are not indexed. Spreading the gain can keep later years under the threshold, but interest is investment income every year. A real estate professional who meets the 500-hour safe harbor in Treas. Reg. 1.1411-4(g)(7) can exclude the sale gain. The character is fixed in the year of sale and carries to every later payment. See the 3.8% tax on a big sale.

Suspended passive losses

Selling your entire interest in a passive activity to an unrelated buyer frees its suspended losses under IRC 469(g). On an installment sale, Section 469(g)(3) releases them pro rata: each year, the share that year's recognized gain bears to the total gross profit. A cash sale frees them all at once. The release requires the entire activity (if rentals are grouped, selling one building may not qualify), and a sale to a related party does not trigger it.

Worked example (engine-computed)

Assumptions (illustrative): married filing jointly, tax year 2026, $120,000 of other ordinary income, passive owner (not a real estate professional), federal tax only (including alternative minimum tax where the engine finds it). Rental sold for $1,500,000, adjusted basis $500,000, after $400,000 of depreciation: $100,000 on cost-segregated 5- and 7-year components (all recaptured) and $300,000 straight line on the building. Gain $1,000,000: $100,000 Section 1245 recapture, $300,000 unrecaptured Section 1250 gain, $600,000 capital gain. Suspended passive losses: $80,000, released pro rata over a gross profit of $1,000,000. Note: $300,000 down, $1,200,000 at 6%, $120,000 of principal a year for 10 years. Gross profit percentage after recapture: 60%.

The gain costs $148,407 spread over eleven years against $212,583 in one cash year, and the 3.8% tax nearly disappears after year three. The note also pays $396,000 of interest, which is taxed as received. With zero down, year one would still carry the $100,000 of cost segregation recapture: $18,940 of tax with no cash from the buyer. Engine: yearTax, 2026 brackets from Rev. Proc. 2025-32. State tax not shown. To test your own property, run your numbers.

The mortgage over basis rule

If the buyer assumes your mortgage or takes the property subject to it, the mortgage is not a payment to you, up to your installment sale basis (adjusted basis plus selling costs plus recapture). The part of the mortgage above that basis is treated as a payment in the year of sale (Temp. Treas. Reg. 15a.453-1(b)(3)).

Using the example property: installment sale basis is $500,000 plus $100,000 of recapture, or $600,000. If the buyer takes over a $700,000 mortgage, the $100,000 excess is a year-one payment. Contract price becomes $1,500,000 minus $700,000 plus $100,000, or $900,000, equal to the gross profit, so the gross profit percentage is 100% and every later dollar of principal is all gain. Heavily refinanced rentals hit this often.

Two related points. Cash the buyer uses at closing to pay off your mortgage is a payment to you in the year of sale, not an assumed debt. And most mortgages have due-on-sale clauses, so assumption needs lender consent; a wrap-around mortgage is the other route, with its own lender risk.

1031 exchange vs installment sale on a rental

A 1031 exchange defers all the gain, including recapture on the building, if you buy like-kind real property of equal or greater value and debt. You stay a landlord, and depreciation recapture on cost-segregated components is avoided only to the extent you acquire replacement Section 1245 property. An installment sale ends your landlord role and gives you a note instead, but recapture income is taxed in year one and each payment carries tax.

• Both: sell, exchange most of the value, and take a buyer's note as boot. Under IRC 453(f)(6) the note's gain is reported as it is paid. See 1031 boot.
• Failed exchange: if the exchange fails, a qualified intermediary's release of funds in the next tax year may let gain be reported then, but cash cannot later be turned into a note. See failed 1031 exchange.
• The full comparison: 1031 vs installment sale.

Protecting the note, costs and IRS stance

Protection: a down payment that covers year-one tax (recapture plus the 1250 layer) and gives the buyer equity; a recorded first-position deed of trust or mortgage; interest at or above the AFR; amortization, any balloon, acceleration, due-on-sale, default and cure terms; the buyer keeps property tax current and the building covered against casualty loss with you named as mortgagee; rent and financial reporting; and a personal guarantee if the buyer is an LLC. If you repossess, Section 1038 limits the gain you recognize; see when the buyer stops paying.

Costs: attorney and escrow fees for the note and deed of trust, a loan servicer if you want one, and your CPA's Forms 6252, 4797 and 8582 each year.

IRS stance: settled law. Errors that draw adjustments: spreading cost segregation recapture, reporting the 25% layer last instead of first, missing the mortgage-over-basis payment, and inadequate stated interest. Notes from the year's sales over $5 million outstanding at year end can trigger the Section 453A interest charge. For every path side by side, Get the full Big Sale Tax Analysis.

Get the full Big Sale Tax Analysis

Frequently asked questions