Selling a Seller-Financed Note: What Happens to Your Installment-Sale Tax Deferral

If you sold property with seller financing and have been reporting the gain as payments arrive, selling the note generally ends that deferral. Under IRC 453B, the gain still waiting in the note is generally reported in the year you sell it, measured as the sale price minus your basis in the note. This page is general information, not tax advice, so take your own figures to a CPA or tax adviser before you set a closing date. A related question, how the rate on a seller-financed note is treated for tax, is covered in AFR and imputed interest.

For a broader look at every tax question a note sale can raise, start with taxes when you sell a note. This page goes deeper on one of them: what happens to the installment method once the note is gone.

The deferral you may already be using

When you sold the property, you did not receive the whole price at once. You took a down payment and a note for the rest. Federal tax law generally lets a seller in that position report the profit over time, as the principal is collected, instead of all in the year of the sale. That is the installment method, set out in IRC 453.

Each year you received principal, part of it was treated as your cost coming back and part as gain. The share that counts as gain is the gross profit percentage: your profit on the sale divided by the contract price. That figure, and the gain reported each year, appear on IRS Form 6252, Installment Sale Income. If you or your preparer filed a Form 6252 with the return for the year of the sale and in the years since, you are using the installment method.

The deferral only works while you hold the note. It assumes the remaining gain will be reported a little at a time as the payer pays. Sell the note and those future payments go to the buyer, so the rules settle the remaining gain at the point of sale instead.

What IRC 453B says, in plain terms

IRC 453B covers the disposition of an installment obligation, meaning a note that came from an installment sale. In general terms:

• If you sell the note, your gain or loss is the amount you receive minus your basis in the note.
• If you dispose of it another way, such as giving it away or cancelling it, the note’s fair market value generally takes the place of the amount received.
• The character of the gain generally follows the property you originally sold. Gain on a note from the sale of land you held for years is generally treated as gain from that land sale.

Your basis in the note is, roughly, the part of the remaining balance that is not deferred profit. Put another way, it is the balance owed minus the gain you would have reported had the payer paid every dollar of it.

A worked example

Illustrative example. The figures on your own note and return will differ.

An owner sold a piece of land for $200,000. Their cost in the land, after adjustments, was $80,000, so the profit was $120,000 and the gross profit percentage is 60%. The buyer paid $20,000 down and signed a note for $180,000. Some years later the balance is $150,000, and a note buyer offers $130,000.

Two things stand out. First, $70,000 of gain that would have been spread across many future years lands in one tax year, which can push income into a higher bracket for that year. Second, the gain is $20,000 less than the $90,000 still deferred, because the price was $20,000 below the balance. The discount you accept on the sale reduces the gain you report. Selling does not create new profit; it mainly moves the timing of profit you already made.

Interest is a separate stream. Interest the payer owed you up to closing is generally ordinary income to you, whether it arrives as a monthly payment or is settled at closing.

Situations that change the picture

• You did not use the installment method. If you elected out and reported the whole gain in the year of the original sale, there is little or no deferred gain left in the note, and the sale is mostly a return of basis. Your adviser will confirm from the old return.
• Depreciation recapture. On a rental or business property, recapture of past depreciation was generally reported in the year of the original sale, not deferred, so it does not come back when the note is sold.
• A transfer at death. Passing a note to heirs at death is generally not treated as a disposition under IRC 453B, but heirs inherit the deferred gain. See how an inherited note is taxed.
• A transfer between spouses in a divorce. IRC 453B has an exception for transfers between spouses, or incident to a divorce, and the receiving spouse generally takes over the position. Talk to your adviser before agreeing a division; see selling a note in a divorce.
• A gift or a cancelled note. Giving the note away or forgiving it can trigger the deferred gain even though you receive no cash.
• Borrowing against the note. For some larger installment sales, the pledge rule in IRC 453A can treat loan proceeds secured by the note as if you had been paid. Ask before using the note as collateral.

What about a partial sale?

In a partial purchase you sell a set number of payments and keep the rest of the note. The tax treatment depends on how the transaction is structured and documented, and it should not be assumed to work like a full sale or like a loan. Some holders look at a partial precisely because it moves a smaller amount of cash, and possibly gain, into the current year, but whether that holds in your case is a question for your adviser. Take the draft agreement with you, and read whether the proceeds from a partial are taxable before the meeting.

Timing the sale

Because the gain is generally reported in the year the note is sold, the closing date matters. A sale that closes in late December falls into one tax year; the same sale a few weeks later falls into the next. If you expect lower income next year, or have losses this year, the choice of date can change what you keep. Your adviser can run both versions once you have a real price to plug in.

State income tax adds another layer, and states differ in how they treat this income.

Compare offers after tax

The figure that matters is what you keep. Set three numbers side by side:

1. The net you would keep after tax from a full sale
2. The net after tax from a partial, if one is offered
3. What you would keep after tax by holding the note and collecting to the end

An offer that looks best before tax can lose its lead once the timing of the gain is counted, and sometimes keeping the note comes out ahead. Every offer we send shows the balance, the buyer’s yield and the discount, which is what a CPA needs to model the sale. If you do not yet have a figure, ask for a free quote and take it to your adviser before you decide anything.

What to bring to your tax adviser

• The return for the year you sold the property, with the Form 6252 if one was filed
• Your most recent return, with the latest Form 6252
• The note and the closing statement from the original sale
• A payment history showing principal and interest received each year
• The current balance and the offers you are weighing, full and partial

With those papers, an adviser can tell you the gross profit percentage, your basis in the note and roughly what a sale would add to this year’s return. That is the number to have before you sign a note purchase agreement.

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