Installment Sale Real Estate Example: Inputs, Reporting, and Interest

An installment sale of real estate lets you spread the capital gain over the years you actually collect the money, instead of paying tax on the whole profit in the year you close. The mechanics come down to a single ratio: your gross profit divided by the contract price. That percentage, fixed at the time of sale, tells you how much of each principal payment is taxable gain and how much is a tax-free return of your basis. Here is a complete installment sale real estate example with the numbers worked out year by year, followed by the adjustments that apply when a mortgage, depreciation, or an unusually low interest rate enters the picture.

The Example: Selling a Lot for $500,000

You sell a vacant investment lot on November 15, 2025, for $500,000. Your adjusted basis is $200,000. No mortgage encumbers the land. The buyer puts $100,000 down at closing and signs a note for the remaining $400,000, payable in four annual principal installments of $100,000 beginning in 2026, with 5% interest on the declining balance.

Three numbers set up the whole calculation:

Selling price: $500,000
Adjusted basis: $200,000
Gross profit: $300,000 (selling price minus basis)

Because there is no mortgage, the contract price equals the full $500,000. The gross profit percentage is $300,000 divided by $500,000, or 60%.¹

That 60% is the number you carry forward for the life of the note. Sixty cents of every principal dollar you receive is capital gain. Forty cents is a nontaxable return of your basis. Interest the buyer pays is separate from this entirely and is taxed as ordinary income in the year you receive it.

Year by Year

2025 (year of sale). You collect the $100,000 down payment. Capital gain: $60,000. Return of basis: $40,000. No interest is due yet.
2026. Principal payment of $100,000 produces another $60,000 of capital gain. Interest at 5% on the $400,000 opening balance adds $20,000 of ordinary income.
2027. $100,000 principal, $60,000 of capital gain. Interest on the $300,000 balance: $15,000.
2028. $100,000 principal, $60,000 of capital gain. Interest on the $200,000 balance: $10,000.
2029. Final $100,000 principal, final $60,000 of capital gain. Interest on the $100,000 balance: $5,000.

Across the five years you recognize the full $300,000 of gain and collect $50,000 of interest. If you held the lot more than a year before the sale, each $60,000 slice qualifies for long-term capital gains rates, which for 2026 run 0%, 15%, or 20% depending on your taxable income. The interest is taxed at your ordinary rates in the year received.

The installment method applies automatically to a sale like this.² There is no election to make. Any sale producing a loss, inventory, dealer property held for resale, or publicly traded securities is excluded and reported in full in the year of sale.³

How the Four Inputs Are Built

The example used round numbers to keep the arithmetic clean. In a real transaction, each input has a precise definition.

Selling price is the total consideration: cash plus the fair market value of any other property the buyer gives you plus any debt of yours the buyer assumes. Adjusted basis is your original cost plus capital improvements, minus any depreciation you claimed or could have claimed. Gross profit is selling price minus adjusted basis, and it is the total gain you will eventually recognize no matter how the payments are structured.

Contract price is the one that trips people up. It is generally the selling price minus any mortgage the buyer assumes, but only to the extent that mortgage does not exceed your basis. If the mortgage exceeds basis, the excess gets added back into the contract price and is also treated as a payment received in the year of sale.⁴

When the Buyer Assumes a Mortgage

Change the example so the lot carries a $150,000 mortgage that the buyer assumes. The selling price is still $500,000, basis is still $200,000, so gross profit is still $300,000. But the contract price drops to $350,000 ($500,000 minus the $150,000 mortgage, which is under basis). The gross profit percentage becomes $300,000 divided by $350,000, roughly 85.7%. A larger share of each principal dollar is taxable now because fewer dollars actually flow to you.

Push the mortgage above basis and the math shifts again. If the mortgage were $250,000 against the same $200,000 basis, the $50,000 excess is treated as a payment you received at closing even though no cash moved for that portion, and that $50,000 is also added back to the contract price.¹ The practical result is accelerated gain in year one before much cash has arrived.

If You Depreciated the Property

The example assumed vacant land, which is not depreciable. If you are selling a rental or a commercial building, part of your gain cannot be deferred.

Any gain that would be ordinary-income depreciation recapture must be recognized in full in the year of sale, cash or no cash. Only the gain above the recapture amount gets spread over the payments.¹ For real property placed in service after 1986, you almost certainly used straight-line depreciation, so the ordinary-income recapture piece is usually zero. The depreciation you did claim becomes “unrecaptured Section 1250 gain,” taxed at a maximum of 25%, and this piece can be deferred under the installment method. The catch: the rules require you to recognize the unrecaptured Section 1250 gain before any of the lower-taxed capital gain, so the earliest payments carry the higher rate.⁵

Older buildings using accelerated depreciation, and personal property components like appliances and fixtures that fall under Section 1245, can produce ordinary-income recapture that hits in the sale year regardless of payment timing.

Setting the Interest Rate

You cannot pick any interest rate you want for the note. If the stated rate is below the Applicable Federal Rate the IRS publishes monthly, part of what the parties called principal gets recharacterized as imputed interest, converting what you expected to be capital gain into ordinary interest income taxed at higher rates.⁶

Which AFR controls depends on the note’s term: short-term for three years or less, mid-term for notes over three but not more than nine years, and long-term for anything beyond nine years. Setting the note’s rate at or above the applicable AFR avoids the imputed interest problem. The 5% in the example was chosen with that floor in mind.

How It Gets Reported

Form 6252 is where the calculation lives on your return. You file it in the year of sale to establish the gross profit percentage, and then every year after that until the note is paid off, even in years when no payment arrives.⁷ The form multiplies that year’s principal receipts by the percentage and produces the recognized gain.

The gain then flows to Schedule D if the property was a capital asset, or to Form 4797 if it was used in a trade or business.³ Interest from the buyer is reported separately as ordinary income. If you financed the sale and the buyer uses the property as a personal residence, Schedule B requires the buyer’s name, address, and Social Security number alongside the interest you received.⁸

High-income sellers should also check the 3.8% net investment income tax, which applies when modified adjusted gross income exceeds $200,000 single or $250,000 joint.⁹ Spreading the gain across years can keep you under the threshold in some years where a single lump sum would have pushed you over.

Choosing Not to Use the Installment Method

Because the method applies automatically, opting out is an affirmative act. You might want to if you have capital losses to absorb the gain, expect higher rates in future years, or simply do not want to track installment income for years. To elect out, report the full gain on a timely filed return (including extensions) using Schedule D or Form 4797 and skip Form 6252. A late election is possible on an amended return filed within six months of the original due date (excluding extensions), by writing “Filed pursuant to section 301.9100-2” at the top. Once made, the election is effectively permanent; revocation requires IRS consent and is rarely granted.²

1
Internal Revenue Service. Publication 537 – Installment Sales
2
Office of the Law Revision Counsel. 26 USC 453 – Installment Method
3
Internal Revenue Service. Topic No. 705 – Installment Sales
4
eCFR. 26 CFR 15a.453-1 – Installment Method Reporting for Sales of Real Property
5
eCFR. 26 CFR 1.453-12 – Allocation of Unrecaptured Section 1250 Gain Reported on the Installment Method
6
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
7
Internal Revenue Service. Form 6252 – Installment Sale Income
8
Internal Revenue Service. About Schedule B (Form 1040)
9
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax