Notes Receivable: What They Are and How a Seller's Note Is Taxed
Notes receivable are amounts owed to you under a written promissory note: a formal promise by the borrower to pay a set principal, usually with interest, on specific dates. They are assets. The part due within the next 12 months is a current asset and the rest is long-term. When you sell property and carry back financing, the buyer's note is a note receivable on your books and an installment obligation for tax.
This article covers the definition and accounting basics, then goes deeper on the part most accounting pages skip: how a note receivable from selling property is taxed.
Notes receivable definition
A note receivable has four features:
- A written promise signed by the borrower (the maker) in favor of the holder (the payee).
- A principal amount, the face value.
- Interest, stated as a rate, or imputed if none is stated.
- A maturity, either one date or a schedule of installments.
Common sources: a customer who converts an overdue account into a note, a loan to an employee or a related company, and, for property owners, a buyer's note from a seller-financed sale.
Notes receivable vs accounts receivable. An account receivable is an informal, usually short, interest-free balance from a sale on credit. A note receivable is a formal written instrument, often longer-term and interest-bearing, and easier to enforce or sell.
Notes receivable vs notes payable. Same document, opposite sides. The holder records a note receivable (asset); the borrower records a note payable (liability).
Is notes receivable an asset? Current or long-term?
It is always an asset. Classification on a balance sheet depends on timing:
| Portion of the note | Classification |
|---|---|
| Principal due within 12 months (or the operating cycle, if longer) | Current asset |
| Principal due after that | Long-term (noncurrent) asset |
| Interest earned but not yet received | Interest receivable, usually current |
A 30-year amortizing seller note is almost entirely long-term. In the example below, only about $4,000 of a $400,000 note is due in year one.
Where a seller's note comes from
When you sell real estate or a business and let the buyer pay over time, the buyer signs a promissory note secured by the property. For tax purposes, IRS Pub. 537 calls this the "installment obligation": "the buyer's note, deed of trust, or other evidence that the buyer will make future payments to you." The installment method under IRC §453 lets you report the gain as the principal is paid. See the installment sale guide for the basics.
Simple example: a seller's note receivable, book and tax
Simple example. Assumptions: you sell a rental for $500,000. Adjusted basis plus selling costs is $200,000, no depreciation recapture, no mortgage assumed. The buyer pays $100,000 down and signs a $400,000 note at 7%, amortized over 30 years, monthly payments of $2,661.21.
Gross profit percentage: $300,000 gain divided by $500,000 contract price = 60% (see gross profit percentage).
At closing:
| Face value | Tax basis in the note | Unreported gain inside it | |
|---|---|---|---|
| Note receivable | $400,000 | $160,000 | $240,000 |
Your tax basis in the note is the unpaid balance minus the gain you would report if it were paid in full (§453B(b)): $400,000 x (1 - 60%) = $160,000.
Year one:
| Year-one payments | Amount | Tax treatment |
|---|---|---|
| Interest | $27,871 | Ordinary income |
| Principal: gain (60%) | $2,438 | Long-term capital gain (installment method) |
| Principal: return of basis (40%) | $1,625 | Not taxed |
Current vs long-term at the end of year one. The unpaid balance is $395,937. The principal due in year two (about $4,357) is the current portion; the rest is long-term.
Book vs tax: the same note, two answers
For financial statements under U.S. GAAP, a seller usually recognizes the full gain when the sale is complete and records the note receivable, with interest income over time. The tax installment method defers gain until principal is collected. The difference is a temporary difference, and a business that keeps GAAP books records a deferred tax liability for it. See installment method accounting for the journal entries.
Individuals who sell a rental or land rarely keep GAAP books. For them, the tax records are what matter: the gross profit percentage, the running unpaid balance and each year's interest.
How notes receivable are taxed
Interest. Ordinary income, taxed as received (or accrued, for a note with original issue discount). It is portfolio income, so passive losses cannot offset it (Temp. Reg. §1.469-2T(c)(3)), and it counts toward the 3.8% net investment income tax. If the note charges less than the applicable federal rate, part of the principal is recharacterized as interest under §483 or §1274; see imputed interest.
Principal. Gain at your gross profit percentage, with the character of the original sale, reported on Form 6252. The rest is return of basis.
Selling, gifting or canceling the note. A disposition under §453B. Gain equals the amount realized (or fair market value, for a gift or cancellation) minus your basis in the note. If the parties are related, the value of a canceled note is treated as no less than its face (Pub. 537). See selling a promissory note.
Transfer to a spouse. A transfer to a spouse, or to a former spouse incident to divorce, is not a taxable disposition; the spouse takes over your basis (Pub. 537).
Death. §453B does not apply to the transmission of an installment note at death; the note is income in respect of a decedent under §691. There is no step-up in basis, and the heirs report the remaining gain as they collect. See installment note at death.
Worthless note. If the buyer cannot pay and the note becomes worthless, a nonbusiness bad debt is treated as a short-term capital loss (§166(d)), generally limited to your basis in the note. If you instead repossess real property under §1038, you cannot take a bad debt deduction for the obligation, and any earlier bad debt deduction is recaptured as income in the year of repossession (Pub. 537).
What to track for a seller's note
- Original sale price, contract price, gross profit and gross profit percentage.
- Unpaid principal at each year end.
- Interest received each year (and the payer's name, address and SSN if the property is their home).
- Your basis in the note (unpaid balance x (1 - gross profit percentage)).
- The signed original note and the recorded deed of trust or mortgage.
These numbers make every later event, a payoff, a sale of the note, a death or a default, a short calculation instead of a reconstruction. Model the payment stream first in the calculator.
Bottom line
Notes receivable are written promises to pay you, recorded as assets, current for the part due within a year and long-term for the rest. A seller's note from an installment sale is also a tax asset with a built-in deferred gain: principal carries gain at your gross profit percentage, interest is ordinary income, and selling, gifting or canceling the note triggers the remaining gain. Keep clean records from day one.
Questions to ask your CPA
- What is my gross profit percentage, and what is my tax basis in the note today?
- How much of this year's payments is interest, taxable gain and return of basis?
- If I keep GAAP books, how do I record the deferred tax on the installment gain?
- What happens to the note and its deferred gain in my estate plan?
- If the buyer defaults, is a bad debt deduction or a §1038 repossession better in my case?
Run your own numbers. Compare a cash sale, seller financing and a structured installment sale side by side, free.
Educational only, not tax, legal or investment advice. Examples are illustrative. Have your CPA or tax attorney review your facts before you act. Hans Goldstein is a licensed insurance agent (CA Insurance License #4273294) and is not a CPA or attorney. He is paid a commission only if a structured installment sale is funded; seller financing pays him nothing. Disclosures.