Installment sales

An installment sale, governed by Section 453, is a way to defer capital gains tax without a 1031 exchange: you sell the property and let the buyer pay you over several years, and you recognize the gain gradually, as you receive the payments. It is simpler than a 1031, it does not lock you into buying replacement real estate, and it can keep you in lower tax brackets. But it carries one trap sharp enough to sink the unwary, and it involves you financing your own buyer.

How it works

In an installment sale, you act as the bank. Instead of the buyer paying you the full price at closing, they pay you over time, often with a down payment plus annual payments and interest, under a promissory note. This is seller financing, and it triggers installment-sale treatment automatically when at least one payment is received after the year of sale.

The tax benefit is that your capital gain is recognized proportionally, as you receive each payment, not all at once. Sell a property with $300,000 of capital gain and collect it over ten years, and you recognize roughly $30,000 of gain a year instead of $300,000 in one year. Spreading the gain can keep you out of the top capital gains bracket and away from the 3.8% net investment income tax threshold in each year, potentially lowering your effective rate. And you earn interest on the financing, an income stream a lump-sum sale would not give you.

An installment sale spreads capital gain over the years you collect payments, recognizing it proportionally, which can keep you in lower brackets and defer part of the tax without a 1031.

The trap: recapture is taxed all at once, up front

Here is the catch that surprises sellers, and it is a big one. Depreciation recapture does not get the installment treatment. All of the depreciation recapture, the Section 1250 recapture on the building and the Section 1245 recapture on any cost-segregated components, is taxed in full in the year of sale, regardless of how little cash you actually received that year.

So a seller who has heavily depreciated or cost-segregated their property can owe a large recapture tax in year one, on money they will not collect for years. Take a small down payment on a property with substantial accumulated depreciation, and you can owe more recapture tax than the cash you received at closing, phantom income in the worst sense. This is the single most important thing to model before doing an installment sale on a depreciated rental: the recapture bill is due up front even though the capital gain spreads out.

All depreciation recapture is taxed in the year of sale, even on payments you have not yet received, so a heavily depreciated property can owe more recapture tax up front than the cash it brought in.

The other costs and risks

Two more considerations. The interest you earn on the seller financing is taxed as ordinary income, generally at higher rates than the capital gains rate applying to the sale itself, so part of your return comes at a worse rate. And there is a large-obligation charge: if your outstanding installment obligations exceed $5 million, you owe interest to the IRS on the deferred tax, which erodes the benefit for big sales.

Then the real-world risk: you are the buyer’s lender. If they default, you have to foreclose to get the property back, and you have taken on the credit risk a normal seller offloads to a bank. An installment sale trades a clean exit for an ongoing financial relationship with your buyer, which is fine with a strong buyer and a nightmare with a weak one.

The bottom line

• An installment sale spreads capital gain over the years you receive payments, under Section 453.
• It can keep you in lower brackets and defer part of the tax without a 1031 or replacement property.
• Depreciation recapture is taxed in full in the year of sale, even on cash not yet received.
• A heavily depreciated property can owe more recapture up front than its down payment.
• Seller-financing interest is ordinary income, and you take on the buyer’s default risk.

For when to sell taxably at all, read selling without a 1031. For the recapture that hits up front, see depreciation recapture in a 1031. For the full picture, start at the 1031 exchanges and exit planning hub.

Last verified August 2026.