Unlock Value: How Installment Sales Create a Win-Win for Buyers and Sellers
By Brian Gibbons, REISkills.com
In the world of real estate and business transactions, creativity often leads to the best deals. One of the most powerful yet underutilized strategies is the installment sale. When a buyer can’t muster the full purchase price upfront, an installment sale isn’t just a fallback option—it can be a strategic tool that benefits both parties.
For the buyer, it provides crucial financing flexibility. For the seller, it can spread the tax burden over several years, potentially smoothing out income and keeping you in a lower tax bracket.
But like any powerful tool, it must be used correctly. The tax rules are intricate, and a misstep can trigger unexpected interest charges or turn capital gains into ordinary income. Let’s break down how to structure an installment sale for a true win-win outcome.
The Core Benefit: Spreading Your Tax Liability
At its heart, an installment sale allows you, the seller, to recognize your taxable gain as you receive the payments, not all at once in the year of the sale.
A Simple Example:
Mario sells his 50% ownership in a company for $1 million. He receives $250,000 at closing and a note for the remaining $750,000, payable in equal installments over three years.
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Result: Mario recognizes 25% of his total gain in the year of the sale and 25% in each of the next three years as he receives principal payments. This defers a significant portion of his tax bill, improving his cash flow.
This deferred gain typically qualifies for favorable long-term capital gains rates or as Section 1231 gain. However, be aware of the 3.8% Net Investment Income Tax (NIIT) and state taxes.
IRS Resource: Publication 537: Installment Sales – The definitive guide to the rules.
Key Calculations: Gross Profit Percentage
To determine how much gain to report each year, you need to calculate your Gross Profit Percentage.
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Contract Price: The sale price minus any qualifying debt assumed by the buyer (with specific basis limitations).
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Gross Profit: The sale price minus your adjusted basis in the property and selling expenses.
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Gross Profit Percentage: (Gross Profit / Contract Price) x 100.
This percentage is then applied to every principal payment you receive to determine the taxable portion.
Critical Pitfalls to Avoid
Not every transaction qualifies, and certain actions can disqualify you.
Ineligible Transactions Include:
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Sales of inventory or publicly traded stock.
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Sales of real estate by dealers (with few exceptions).
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Sales of depreciable property to a related party (as defined by the IRS).
IRS Resource: Related Parties – Installment Sales (See Part of Pub 537)
Actions That Accelerate Tax:
If your installment note is:
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Pledged as security for a loan,
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Used to satisfy another debt, or
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Effectively secured by cash or cash equivalents,
…the IRS may deem the entire note payable immediately, forcing you to recognize all gain in the current year.
The Depreciation Recapture Surprise
This is a major “gotcha.” While capital gain is deferred, depreciation recapture under Sections 1245 and 1250 is not.
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The Rule: Any gain attributable to previously taken depreciation deductions must be recognized as ordinary income in the year of the sale—no deferral allowed.
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Impact: This can create a significant tax bill in Year 1, even if you received very little cash at closing. Plan for this liability upfront.
The Non-Dealer Interest Charge Rule: A Hidden Cost
This is a crucial advanced topic. If you are not a dealer in the property sold, a special rule may require you to pay interest to the IRS on your deferred tax liability.
The rule applies if:
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You sold property for more than $150,000, and
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The total face amount of all such installment notes receivable from that year exceeds $5 million at year-end.
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The Charge: You must pay interest on the deemed deferred tax from these large notes. The rate is the federal underpayment rate (e.g., 8% for Dec. 2023).
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The Sting: For individuals, this interest charge is nondeductible personal interest. You also must include the interest income from the buyer in your taxable income ( taxed at ordinary rates up to 37%), but you cannot deduct the interest you pay to the IRS.
Bottom Line: This rule can erase the benefits of deferral for high-value transactions. Proper planning with a tax pro is essential to minimize or avoid this charge.
Should You Elect Out of Installment Treatment?
Sometimes, it’s smarter to take the hit now. You can elect out of installment treatment and recognize all the gain in the year of sale. Consider this if:
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You have current-year capital losses, NOLs, or tax credits to shelter the gain.
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The deferred gain is small and would be taxed at an acceptable rate.
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You fear future tax rates will be significantly higher.
This election must be made by the due date (with extensions) of your tax return for the year of the sale and is generally irrevocable.
The REISkills Bottom Line
An installment sale is a fantastic tool for facilitating deals and managing tax liability. However, it is not a simple “set it and forget it” strategy.
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Always calculate depreciation recapture first.
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Be hyper-aware of the related-party rules.
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If your deal is over $150,000, be mindful of the $5 million threshold for the interest charge rule.
The #1 takeaway: The complexity of these rules demands professional guidance. A great deal can be undone by poor tax planning.
Before you close, consult with your tax advisor. Structure the note correctly, understand the implications, and ensure your win-win deal doesn’t become a tax-time loss.
Disclaimer: This article is for educational purposes only and does not constitute tax or legal advice. Please consult with a qualified tax professional regarding your specific situation.
