How to Use Installment Sales to Spread Real Estate Capital Gains Over Time

11 Dec 2025 How to Use Installment Sales to Spread Real Estate Capital Gains Over Time

If you’re getting ready to sell appreciated real estate, finding the right buyer is just one part of the equation. The other (often more complicated) part is managing the tax consequences.

In many markets, property values have climbed significantly over the past decade. That appreciation, while welcome, can bring a hefty capital gains bill when you sell. Depending on the size of the gain, you could find yourself pushed into a higher tax bracket, subject to the 3.8% Net Investment Income Tax, or phased out of certain deductions and credits.

The good news is that there are ways to optimize how and when those gains are recognized. One of the more straightforward options is an installment sale. While it’s not the right fit for everyone, it can be a useful strategy for spreading capital gains over time and potentially smoothing out your overall tax exposure.

If you’re exploring ways to manage the tax impact of a sale, understanding how installment sales work is a good place to start.

What is an installment sale?

An installment sale is a method that lets you defer part of your capital gains tax by receiving payment over time. Instead of taking the entire sale price in one lump sum and recognizing all of the gain in the year of sale, you report a portion of the gain as you receive payments in future years. However, it’s worth noting that the installment method isn’t automatic. If you receive payments over time and want to defer the gain under Section 453, you must elect the installment method on your tax return in the year of sale. If you don’t, the IRS will treat the transaction under the general rule, which means recognizing the entire gain upfront, regardless of how or when the payments are received.

The installment method is typically used when you, as the seller, finance the sale directly with the buyer. Each payment you receive includes three components: a return of your basis (your original investment), interest income (if applicable), and a portion of the capital gain. The gain is taxed as it’s realized over time, rather than all at once, which can significantly affect your total tax bill, especially if the gain is large enough to otherwise push you into a higher bracket.

For example, say you sell a property for $1.5 million that you originally purchased for $600,000. Your gain is $900,000. If you agree to receive the $1.5 million in five equal annual payments of $300,000, you’ll recover part of your original investment and recognize part of the gain with each payment.

Each year, you’d report a portion of:

• Your basis: $600,000 divided evenly over five years = $120,000 per year (non-taxable return of capital),
• Capital gain: $900,000 gain / $1.5 million sale price = 60% of each principal payment is taxable as capital gain, or $180,000 per year,
• Interest: If you charge interest on the note (as required by the IRS under imputed interest rules), any interest received is taxed separately as ordinary income in the year it’s received.

So in a given year, a $300,000 payment might break down into $120,000 return of basis (non-taxable), $180,000 long-term capital gain, and perhaps $30,000 of interest income (depending on the terms). Only the gain and the interest would be taxable.

That said, not all of the gain may be treated the same way. If you’ve taken depreciation on the property, you’ll likely have to deal with depreciation recapture. Here, the rules vary depending on the type of property sold.

For real property, like buildings, the portion of the gain attributable to unrecaptured Section 1250 depreciation can still be deferred using the installment method, but it’s taxed at a maximum rate of 25% when recognized (IRC §1(h)(1)(D)).

However, many properties include components classified as Section 1245 property, such as certain fixtures, equipment, and other personal property identified through cost segregation studies. Gain attributable to Section 1245 depreciation must be recognized in full in the year of sale, and it’s taxed as ordinary income (IRC §1245(a)). This portion cannot be deferred under the installment method.

In practice, this means that even if you’re selling a building under an installment agreement, a portion of the gain may need to be recognized immediately. A careful review of the property’s depreciation history, asset classification, and cost recovery schedules is essential before assuming full eligibility for installment treatment.

Why spread out the gain?

The main appeal of an installment sale lies in the ability to control the timing of your income. When a large gain is recognized all at once, it can significantly increase your taxable income for that year – and with it, your total tax bill. For 2025, the long-term capital gains rate is 15% for most taxpayers, but it jumps to 20% once your taxable income exceeds $600,050 if you’re married filing jointly, or $533,400 if you’re filing as a single taxpayer. For those married filing separately, the 20% rate applies if your income exceeds $300,000. Additionally, if your modified adjusted gross income exceeds $250,000 (MFJ), $200,000 (single), or $125,000 (MFS), the 3.8% Net Investment Income Tax applies to the lesser of your net investment income or the amount over those thresholds (IRC §1411).

It’s easy to assume these thresholds only apply to a select few, but depending on where you live and what you’re selling, crossing them might be more common than you think.

Let’s say you’re married, filing jointly, earning just over $250,000 in combined salary and investment income. You’ve owned a small multi-family building in the New York metro area for 15 years, purchased for $700,000, and now selling for $1.6 million. After closing costs and accounting for depreciation taken over the years, your taxable gain is approximately $750,000. Adding that gain to your regular income puts you over $1 million in taxable income for the year – well above the 20% capital gains threshold. As a result, part of your gain will be taxed at the 20% rate, and you’ll also be subject to the 3.8% Net Investment Income Tax on a significant portion of the sale proceeds.

By contrast, if you structure the sale using an installment method over five or ten years, you might be able to recognize the gain more gradually, keeping your taxable income below the 20% capital gains threshold in any given year, and possibly limiting or avoiding the 3.8% surtax (depending on other income) as well.

Installment sales can also help with cash flow. If you’re not in a rush to receive the full proceeds upfront, and you’re confident the buyer will meet their obligations, this structure can provide a steady stream of payments that align with your future spending or investment needs. That’s especially relevant if you’re selling real estate as part of a broader business exit or retirement plan. In those cases, installment payments can serve as a reliable income stream in the early retirement years (functionally similar to an annuity or private pension), while also spreading out the associated tax burden.

Of course, you could sell the property in a lump sum, pay the taxes, and reinvest the remainder into a portfolio designed to generate income. But deferring the tax through an installment structure often leaves more principal in play, especially in high-gain scenarios. And because the IRS requires interest to be charged on installment notes, you’ll also receive a separate stream of interest income, which is taxed as ordinary income but can supplement principal payments in a predictable way.

When does it make sense?

Installment sales work best when you expect to receive payments over a number of years and want to reduce your tax exposure in the near term. It can also be a practical option when market conditions make it easier to close a deal by offering seller financing, especially in a high-interest or tight credit environment.

But there are trade-offs. If you need the full proceeds immediately, you’ll likely need to explore other options. And because you’re taking on the role of lender, there’s always the risk that the buyer could default. If that happens, and you have to repossess the property, you may be required to recognize the remaining gain all at once, or deal with complicated tax treatment under IRC §453B.

Also, if you transfer the installment note down the road, whether through a sale, gift, or bequest, you might trigger recognition of the remaining deferred gain at that point. Estate planning around installment notes can be complex, so if you expect to hold the note long-term or include it as part of your estate, it’s worth addressing those implications up front.

If you’re selling to a related party, which includes certain family members, trusts, or entities you control, special rules apply under IRC §453(e). In these cases, your ability to defer capital gain through the installment method is more limited. One of the key restrictions is the two-year resale rule: if the related buyer sells the property within two years of acquiring it from you, the IRS may require you to recognize the remaining deferred gain immediately, even if you haven’t yet received all the installment payments. This rule is designed to prevent taxpayers from using related parties to artificially stretch out gain recognition while effectively cashing out.

Because of how broadly the term “related party” is defined, it’s important to analyze any ownership or control relationships before assuming an installment sale will qualify for deferral in these situations.

Installment sales vs. other strategies

An installment sale isn’t the only way to manage capital gains on real estate. For business or investment properties, Section 1031 exchanges allow you to defer all capital gain by reinvesting in like-kind property. However, 1031 exchanges come with strict timelines and rules about replacement property, and they don’t apply to personal-use property like your primary residence.

Charitable Remainder Trusts (CRTs) are another strategy. These allow you to donate the property to a trust, receive a charitable deduction, and get an income stream for life or a term of years. The trust sells the property tax-free and pays you income, spreading the tax cost out over time. CRTs offer powerful planning opportunities, but they come with legal complexity, administrative overhead, and irrevocability.

Compared to these strategies, an installment sale is relatively simple and doesn’t require trust structures or third-party custodians. But it doesn’t eliminate the gain – it just shifts the timing. That distinction matters if you’re weighing your options.

Proceeding thoughtfully

If you’re considering an installment sale, the key is to understand not just the tax deferral but the full financial implications. You’re taking on the role of lender, which means you’re exposed to credit risk. You’ll need a well-drafted promissory note, appropriate interest terms (at or above the Applicable Federal Rate under IRC §1274), and a clear plan for what happens if payments are delayed, defaulted, or pre-paid.

It’s also worth modeling a few different scenarios: What would your tax exposure look like under a lump-sum sale versus a 5 or 10-year installment plan? How do those outcomes change if interest rates move, if you incur unexpected medical or long-term care costs, or if you’re planning to gift or bequeath the note?

None of these decisions should be made in isolation. Installment sales can be a helpful tool, but only when coordinated with your broader goals for investment, retirement, charitable giving, and estate planning.

If you’re considering an installment sale and would like to model a few different scenarios with an expert advisor, please contact our office. We can help ensure the structure aligns with your broader financial goals and anticipates potential tax implications.

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