What Is a Section 453 Installment Sale?

An installment sale provides a method for deferring tax on a property sale where payments are spread out over time. Governed by Section 453 of the Internal Revenue Code, this approach allows a seller to recognize gain, and pay the corresponding tax, as payments are received from the buyer instead of all at once in the year of the sale. This aligns the tax liability with the seller’s actual cash flow from the transaction. The income recognized each year is proportional to the payments received that year.

Qualifying for an Installment Sale

The primary requirement for an installment sale is that a seller disposes of property where at least one payment is scheduled to be received after the tax year in which the sale occurs. This structure automatically qualifies the transaction for installment method reporting unless the seller chooses otherwise.

Certain types of property are eligible for installment sale treatment. This includes real estate, such as land or buildings, and ownership interests in a privately held business, like a partnership or a closely held corporation. The sale of personal property that is not considered inventory can also qualify.

Conversely, the Internal Revenue Code explicitly excludes several types of property from being sold via the installment method. A primary exclusion is for inventory, meaning property held for sale in the ordinary course of a trade or business. Another exclusion applies to stocks and securities traded on an established market, and the entire gain from these sales must be recognized in the year of the sale.

Calculating and Reporting Gain

To correctly report income from an installment sale, a seller must calculate the overall gain and determine the portion of each payment that represents taxable income. This process requires understanding three figures: the selling price, the adjusted basis of the property, and the gross profit. The selling price is the total amount the property is sold for, including money, the fair market value of any property received, and any of the seller’s debt assumed by the buyer. The adjusted basis is the original cost of the property, plus additions like improvements, and minus deductions such as depreciation. The gross profit is the selling price minus the adjusted basis.

Once these figures are established, the next step is to calculate the gross profit percentage. The formula is the gross profit divided by the selling price. This percentage remains constant for every payment received throughout the life of the installment agreement and represents the proportion of each dollar received that is considered a taxable gain.

For example, assume a property is sold for $500,000. The seller’s adjusted basis in the property is $300,000, resulting in a gross profit of $200,000. The gross profit percentage would be 40% ($200,000 gross profit ÷ $500,000 selling price). If the buyer makes a principal payment of $50,000 in a given year, the seller must report $20,000 of that payment as taxable gain for that year. Any portion of the payment that is designated as interest must be reported separately as ordinary interest income.

These calculations are reported to the IRS on Form 6252, Installment Sale Income. This form must be filed with the seller’s tax return for the year of the sale and for each subsequent year in which a payment is received.

Special Rules and Considerations

One of the most significant special rules involves depreciation recapture. If the sold property was depreciable, any gain attributable to that depreciation must be reported as ordinary income in the year of the sale. This recapture income is recognized immediately, regardless of whether any payments are received in that first year, and it is not eligible for deferral under the installment method.

Another consideration arises when the total value of installment sales is substantial. Under Section 453A, if the face amount of all installment obligations from sales of property with a price over $150,000 exceeds $5 million at the close of the tax year, the seller may owe interest to the IRS on the deferred tax liability. This interest charge is calculated on the amount of deferred tax related to the obligations exceeding the $5 million threshold.

Transactions between related parties are also subject to specific regulations. If a seller uses the installment method for a sale to a related person, such as a family member or a controlled entity, a “second disposition rule” may apply. If the related party resells the property within two years of the original purchase, the initial seller may be forced to immediately recognize any remaining deferred gain. This rule prevents a related party from acting as an intermediary to quickly cash out of the property while the original seller continues to defer the tax liability.

Electing Out of the Installment Method

A taxpayer can choose to report the entire gain in the year of the sale by affirmatively electing out of the installment method. This decision is binding and, once made, generally cannot be revoked without IRS consent.

To make the election, the seller must report the full gain from the sale on their tax return by its due date, including any extensions. This is accomplished by reporting the transaction on either Schedule D (Capital Gains and Losses) or Form 4797 (Sales of Business Property), depending on the nature of the asset sold.

This election means the seller will pay tax on the entire gain immediately, even if the payments from the buyer will be received in future years. This might be a strategic choice if the seller expects to be in a higher tax bracket in later years or has sufficient capital losses in the current year to offset the gain.