When you carry back a note on a rental you sell, most of the gain can be reported as the buyer pays you. That is the installment method under IRC §453.

Two pieces do not wait for the payments. Any depreciation recapture that is taxed as ordinary income, which mostly comes from cost segregation and bonus depreciation, is taxed in the year of sale. And the straight-line depreciation gain taxed at up to 25% is reported first, before the lower-rate capital gain.

Forum threads get both of these wrong in opposite directions. Some say all depreciation is taxed up front. Others say none of it is. The real rule sits in between.

How the installment method works

An installment sale is any sale where at least one payment arrives after the end of the tax year of the sale. If the sale produces a gain, §453 applies automatically unless you elect out.

Each principal payment is split into three parts:

  • Return of basis. Not taxed.
  • Gain. Taxed in the year you receive it. The share is your gross profit percentage, which is your gross profit divided by the contract price.
  • Interest. Taxed as ordinary income, separately from the gain.

You report the sale on Form 6252 in the year of sale and every year after that until the note is paid off, even in a year with no payment.

You cannot use the installment method for a loss. It also does not apply to property you hold for sale to customers, so most flips are out. It is for investment and rental property.

What is taxed in the year of sale no matter what

Section 453(i) says recapture income is recognized in the year of the sale, even if you receive no cash that year. Recapture income means the amount treated as ordinary income under §1245 or §1250.

For a rental, that usually covers:

  • Components reclassified in a cost segregation study. Appliances, carpet, cabinetry, and similar items depreciated as 5-year or 7-year §1245 property. The depreciation you took on them comes back as ordinary income, up to the gain allocated to those items. See cost segregation and bonus depreciation in 2026.
  • Land improvements depreciated faster than straight line. Fences, paving, and landscaping are usually 15-year property. Under §1250(b), depreciation above what straight line would have allowed, including bonus depreciation, is "additional depreciation" taxed as ordinary income.

The IRS adds the recapture amount to your installment sale basis. That lowers the gross profit percentage on the payments that follow, so you are not taxed on the same dollars twice.

If you took big bonus depreciation after a cost seg study, this can be a large number in a year when you received only the down payment. Plan the cash for it. See REPS, cost segregation, and the excess business loss limit for how those deductions were created.

The 25% gain is spread, but it comes first

Straight-line depreciation on the building itself is not §1250 ordinary recapture for a rental placed in service after 1986. It is "unrecaptured §1250 gain," taxed at up to 25% under §1(h).

Because it is not recapture income, it is not pulled into the year of sale. It is reported on the installment method like the rest of the gain.

The catch is the order. Treasury Regulation §1.453-12 says the unrecaptured §1250 gain is taken into account before the regular capital gain. The early payments carry the 25% gain. The 15% or 20% capital gain comes later.

A worked example

This is a hypothetical, not a client.

You bought a duplex for $600,000 and have taken $150,000 of straight-line depreciation. Your adjusted basis is $450,000. You sell for $1,200,000 with $300,000 down at closing and a $900,000 note paid over the next ten years. Ignore selling costs and state tax.

No cost segregation:

  • Total gain is $750,000. That includes $150,000 of unrecaptured §1250 gain.
  • Gross profit percentage is $750,000 divided by $1,200,000, or 62.5%.
  • Year-one gain on the $300,000 down payment is $187,500.
  • Under §1.453-12, the first $150,000 of that is the 25% gain. The other $37,500 is regular long-term capital gain.
  • The remaining $562,500 of gain is reported as principal comes in.

Same sale, but $80,000 of the depreciation came from a cost seg study on §1245 items, and $80,000 of the price is allocated to them:

  • The $80,000 is ordinary income in year one, even though you collected only $300,000.
  • It is added to your installment sale basis, so gross profit drops to $670,000 and the percentage to about 55.83%.
  • Year-one installment gain is $167,500. Add the $80,000, and year one shows $247,500 of gain instead of $187,500.
  • The remaining $70,000 of unrecaptured §1250 gain still comes first. With this down payment, all of it lands in year one.

If less of the price is allocated to the §1245 items, the recapture is lower. The allocation matters and should be supported.

Selling to family or to your own entity

Related-party installment sales have two traps.

Depreciable property to a controlled buyer. Under §453(g), if you sell depreciable property to a related person as defined in §1239(b), the installment method does not apply. All payments are treated as received in the year of sale. That definition includes an entity more than 50% owned by you, and a trust in which you or your spouse is a beneficiary. Selling a rental to your own LLC or S corporation on a note usually lands here. There is an exception if you show the IRS that avoiding federal income tax was not a principal purpose.

A related buyer who resells within two years. Under §453(e), if a related buyer sells the property within two years of your sale, the amount they receive is treated as paid to you at that time. Related persons for this rule include your spouse, children, grandchildren, parents, siblings, and entities you control.

Form 6252 asks extra questions for related-party sales in the year of sale and the two years after.

Other rules that catch sellers

Interest on deferred tax above $5 million. Section 453A charges interest on the deferred tax when the sales price is over $150,000 and the face amount of all such notes that arose during the year and are still outstanding at year end exceeds $5,000,000. The interest is added to your tax each year the note stays outstanding.

Borrowing against the note. Under the pledge rule in §453A(d), if you use an installment note from a sale over $150,000 as security for a loan, the loan proceeds are treated as a payment on the note. That accelerates gain.

Escrowed payments. If the buyer funds an irrevocable escrow account that will make the remaining payments, Publication 537 says the sale cannot be reported on the installment method.

Charging too little interest. If the note does not carry adequate stated interest, part of the principal is recharacterized as interest. The test is based on the applicable federal rates the IRS publishes each month.

A mortgage larger than your basis. If the buyer takes over your loan and it exceeds your installment sale basis, the excess is treated as a payment in the year of sale.

Dying while the note is outstanding. The note passes to your heirs, and they pay tax on the payments the same way you would have. Under §691(a)(4) and §1014(c), the note does not get the stepped-up basis that inherited real estate usually gets. For an older owner, that can tilt the decision toward holding instead of selling on a note.

Passive losses and the 3.8% tax

If the rental has suspended passive losses, an installment sale of your entire interest frees them in pieces, in the same ratio as the gain you recognize each year. See what happens to suspended passive losses when you sell.

The gain can also be subject to the 3.8% net investment income tax in the years you recognize it. The thresholds under §1411(b) are $250,000 on a joint return and $200,000 for a single filer, and they are not adjusted for inflation. Spreading the gain can keep some years under the threshold. See real estate professional status and the net investment income tax.

Electing out

You can choose to report the whole gain in the year of sale. You elect out by reporting the sale on Form 4797 or Form 8949 instead of Form 6252, on a return filed by the due date including extensions.

If you filed on time without electing, the Form 6252 instructions allow the election on an amended return filed within six months of the original due date, excluding extensions. Once made, the election can be revoked only with IRS consent.

Electing out can make sense when you have large losses to absorb in the year of sale, or when you expect your rate to be higher in later years.

California

California has no lower rate for capital gains. The FTB says all capital gains are taxed as ordinary income, so the 25% bucket and the 15% or 20% bucket do not exist on the state return.

For California real property, the 2026 Form 593 instructions say escrow withholds 3 1/3% of the down payment. After closing, the buyer must withhold on the principal portion of each later payment. If you elect out and report the entire gain on your California return, you can ask the FTB to release the buyer from withholding on later payments. The FTB says it will approve or deny the request within 30 days, and the buyer keeps withholding until it approves.

If you are weighing a note against a 1031 exchange, see our 1031 exchange CPA page and how to protect your 1031 exchange from taxable boot.

Common mistakes

  • Assuming all depreciation is taxed up front, or assuming none of it is.
  • Forgetting cost seg recapture in the year of sale and having no cash set aside for it.
  • Selling a rental on a note to your own LLC or S corporation and expecting installment treatment.
  • Pledging the note for a loan right after closing.
  • Writing a note with no interest or below-market interest.
  • Not filing Form 6252 in a year with no payment.

Frequently asked questions

Is depreciation recapture taxed in the year of sale on an installment sale?

Recapture that is ordinary income under §1245 or §1250 is taxed in the year of sale even if you receive no payment that year, under §453(i). For a rental, that is mostly depreciation on cost segregation components and accelerated or bonus depreciation on land improvements. Straight-line depreciation on the building is unrecaptured §1250 gain and is spread over the payments.

How is unrecaptured §1250 gain taxed on an installment sale?

It is reported on the installment method, but Treasury Regulation §1.453-12 requires it to be taken into account before the regular capital gain. Your early payments carry the gain taxed at up to 25%, and the lower-rate capital gain comes after it is used up.

Can I sell my rental to my own LLC on an installment note?

Usually not with installment treatment. Under §453(g), a sale of depreciable property to a related person under §1239(b), including an entity more than 50% owned by you, treats all payments as received in the year of sale. An exception applies if you show the IRS that tax avoidance was not a principal purpose.

Do I have to charge interest on a seller-financed sale?

Yes, in practice. If the note does not carry adequate stated interest based on the applicable federal rates, part of the principal is recharacterized as interest, which is taxed as ordinary income. The interest you collect is reported each year separately from the gain.

What is the $5 million rule for installment sales?

Section 453A charges interest on the deferred tax when a property's sales price is over $150,000 and the face amount of all such notes that arose during the year and are still outstanding at year end is more than $5,000,000. The interest is added to your tax for each year the note stays outstanding.

Does California allow installment sale reporting on real estate?

Yes, and California taxes the gain as ordinary income because it has no lower capital gains rate. On California real property, escrow withholds 3 1/3% of the down payment and the buyer withholds on the principal of later payments, unless you elect out and the FTB approves a release.

Talk it through with us

Bring the purchase closing statement, your depreciation schedules, any cost segregation study, and the proposed terms of the note. We will show you what is taxed in year one, what is spread, and how the federal and California numbers compare with a full cash sale or a 1031 exchange. Book a complimentary consultation.

LaviCPA is a Los Angeles CPA firm for real estate investors. Shawn Lavi, CPA, is the firm's principal. Elias Lavi, CPA, is its founder and co-owner.