Take the money over years and the gain follows the payments — except for the part the code pulls into year one. Here is how it works, what the down payment decides, and what you take on when you become the lender.
In an installment sale, the buyer pays you over time and you report the gain as payments arrive rather than all at once. It is the default treatment under IRC §453 for any sale with at least one payment after the year of sale — you have to affirmatively elect out if you don’t want it.
Each payment carries a slice of gain determined by your gross profit ratio — gross profit divided by contract price. Receive twenty percent of the price this year and you recognize roughly twenty percent of the gain this year. The interest the buyer pays is separate: it is ordinary income every year, taxed at your regular rates, and the code will impute a rate if the note doesn’t state an adequate one.
The appeal is simple. Instead of one enormous taxable year, you get a series of smaller ones — potentially staying under bracket thresholds, under the 3.8% surtax line, and under the Medicare surcharge tiers that a single large sale would blow through.
This is the trap, and it catches sellers who structured the note precisely to avoid a big first year.
§453(i) pulls depreciation recapture forward. Any amount that would be taxed as ordinary income under §1245 or §1250 must be recognized in the year of the sale — the full amount, as if every payment had been received that year. It does not matter that the buyer has paid you almost nothing.
Which part of your depreciation is affected depends on what you depreciated. Straight-line depreciation on the building generally produces no §1250 ordinary recapture. It comes back as unrecaptured §1250 gain, taxed at up to 25% — and that is eligible for installment treatment. But under Treas. Reg. §1.453-12 it is recognized first, ahead of any 15% or 20% gain. So it is spread, but front-loaded.
The piece that is genuinely due up front is §1245 property — appliances, flooring, fixtures, and anything a cost-segregation study broke out of the building. That recapture is ordinary income, and all of it lands in year one.
The practical consequence: a seller who did a cost-segregation study years ago can owe a meaningful ordinary-income tax bill in the first year of an installment sale while holding a small down payment. The study that accelerated deductions accelerates the tax on the way out.
The size of the first check decides how much of the benefit you actually get, and how much risk you take on:
| Large down payment | Little or none | |
|---|---|---|
| Gain recognized in year one | High — a large slice of the gain arrives immediately | Low — most gain defers to later years |
| Bracket and surtax exposure | Can push through the 25% band and over the 3.8% surtax line anyway | Better spread, more years under the thresholds |
| Depreciation recapture | Ordinary recapture still due in full, year one | Same — and now you may not have the cash to pay it |
| Cash in hand | Substantial, immediately usable | Minimal — your return depends on the note performing |
| If the buyer defaults | You keep the down payment and the property | You get the property back, having recognized tax on gain you never collected |
A useful way to size it: the down payment should at minimum cover the tax that comes due in the year of sale. A note structured so that year one’s tax exceeds year one’s cash is a plan that funds the IRS out of savings.
None of this makes an installment sale wrong. It makes it a financing decision wearing a tax-planning coat — and the question of whether the note, the buyer, and the security behind it are sound belongs with your attorney and your tax professional before the structure is chosen. If the goal is deferral without becoming a lender, an exchange and the other exits are the comparison worth running.
Partly. Under IRC 453(i), any depreciation recaptured as ordinary income under section 1245 or 1250 must be recognized in full in the year of sale, no matter how little the buyer has paid. For most rental buildings depreciated straight-line, there is no section 1250 ordinary recapture; that depreciation returns as unrecaptured section 1250 gain taxed at up to 25%, which can be spread over the installments but is recognized before any 15% or 20% gain. Section 1245 property such as appliances, flooring, and cost-segregation components is the piece genuinely due in year one.
It does not reduce the total gain; it spreads when the gain is recognized. Smaller annual amounts can keep you inside lower brackets, below the 3.8% net investment income tax threshold, and under Medicare surcharge tiers that one large sale would exceed. The interest the buyer pays is separate ordinary income each year.
The tax argument favors a smaller down payment, since less gain is recognized in the first year. The risk argument favors a larger one, because you keep it if the buyer defaults. A practical floor: the down payment should at least cover the tax that comes due in the year of sale, including any recapture accelerated into that year.
You generally repossess the property, and there are specific rules for computing gain or loss on repossession. The uncomfortable case is a low-down-payment note where you already recognized recapture in year one on gain you never collected. Whether the note is adequately secured is a legal question to settle with your attorney before closing, not after.
The free briefing walks the order of operations before you list — and what each path costs.
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