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Seller Financing Rental Property: Tax Rules and a Worked Example

By Hans Goldstein · Updated 2026-09-27

Yes, you can sell a rental property with seller financing and report the gain on the installment method (IRC §453), but a rental adds four tax layers a plain land sale does not have. Ordinary depreciation recapture, including cost-segregation recapture, is taxed in the year of sale no matter how you are paid (§453(i)); unrecaptured §1250 gain is spread with the payments but taken first (Reg. §1.453-12); suspended passive losses are released in proportion to the gain you recognize each year (§469(g)(3)); and the gain and interest may carry the 3.8% net investment income tax. On top of that, your existing mortgage and your tenants need a plan before you sign.

This article covers the rental-specific rules. For the basics, see our seller financing guide; for choosing the terms, see how to structure seller financing.

How the gain on a rental is split

When you sell a rental, your total gain (price minus selling costs minus adjusted basis) has up to three parts, and each is treated differently on the installment method:

Most residential rentals placed in service after 1986 have no §1250 ordinary recapture, because the building was depreciated straight line and "additional depreciation" means only depreciation above straight line (§1250(b)(1)). All of the building's depreciation is then unrecaptured §1250 gain, which does spread. The exception is a property with a cost segregation study: the reclassified components are §1245 property (or §1250 land improvements taken above straight line), and their recapture is taxed in year one in full. The recapture amount is also added to your basis for figuring the gross profit ratio, so it is not taxed twice (IRS Pub. 537). See installment sale depreciation recapture and section 1245 recapture.

Unrecaptured §1250 gain comes out first. Reg. §1.453-12(a) reports it on the installment method, and "the unrecaptured section 1250 gain is taken into account before the adjusted net capital gain." So the first payments, including your down payment, carry the 25%-maximum layer, and the lower-rate appreciation comes later.

Suspended passive losses come out in step with the gain

Many rental owners carry years of suspended passive losses. A fully taxable sale of your entire interest in the activity to an unrelated buyer frees them to offset other income (§469(g)(1)(A)). With an installment sale, §469(g)(3) releases them gradually:

"In the case of an installment sale of an entire interest in an activity to which section 453 applies, paragraph (1) shall apply to the portion of such losses for each taxable year which bears the same ratio to all such losses as the gain recognized on such sale during such taxable year bears to the gross profit from such sale."

In plain terms: if you recognize 28% of your total gain this year, 28% of the suspended losses are released this year. Three conditions to check with your CPA:

• Entire interest in the activity. If the property is grouped with other rentals as one activity, selling one building may not be a disposition of the whole activity.
• Unrelated buyer. A sale to a related party under §267(b) or §707(b)(1) does not release the losses until the property leaves the related group (§469(g)(1)(B)).
• A taxable sale. A like-kind exchange does not release them.

The released losses are treated as non-passive, so they can offset the gain itself, the interest on your note and your other income in the year they are released.

The 3.8% net investment income tax

The NIIT is 3.8% of the lesser of your net investment income or your modified AGI above $250,000 (joint), $125,000 (married filing separately) or $200,000 (other filers) (§1411(a)(1), (b)). Net investment income includes interest and gain from disposing of property not held in a non-passive trade or business (§1411(c)(1)). For most rental owners, both the gain and the note interest count.

Seller financing helps here in two ways. Spreading the gain can keep more years under the threshold. And losses released under §469(g) reduce net investment income in the year they are allowed (Reg. §1.1411-4(g)(9)). A real estate professional who meets the 500-hour test in Reg. §1.1411-4(g)(7) may be outside the NIIT on the rental entirely; that is a CPA question.

Interest on the note

The interest you receive is ordinary income, reported each year, and it is portfolio income, not passive income (Temp. Reg. §1.469-2T(c)(3)). The note must carry at least the applicable federal rate for its term, tested at the lowest AFR for the 3-month period ending with the month of the binding contract (§1274(d)(2)). For September 2026 the annual mid-term AFR (notes over 3 up to 9 years) is 4.49% and the long-term (over 9 years) is 5.12%. See seller financing interest rate and the AFR.

Depreciation stops at the sale

You stop depreciating the property when you sell it (IRS Pub. 527). In the year of sale you claim a partial year under the mid-month convention. After that you hold a note, not a building, and the buyer depreciates its own cost.

§453A on larger notes

Apartment buildings and larger multifamily deals can produce big notes. If you hold installment notes from sales over $150,000 and their face amount exceeds $5,000,000 at the end of a year, you owe an annual interest charge on the deferred tax attributable to the excess (§453A(b)(1), (b)(2), (c)). Pledging such a note as security for a loan is treated as a payment (§453A(d)). Rentals are not exempt; only farm property and personal-use property are (§453A(b)(3)). See the §453A interest charge and pledge rule.

Your existing mortgage

Most rentals still carry a loan, and almost every loan has a due-on-sale clause. Federal law lets the lender enforce it (12 U.S.C. §1701j-3(b)). The exemptions in §1701j-3(d) apply only to residential property with fewer than five dwelling units and cover transfers such as to a spouse or children, into your own living trust, a junior lien, or a lease of three years or less with no purchase option. A sale to an unrelated buyer on seller financing is not on the list, and for a building with five or more units none of the exemptions apply.

Your choices:

• Pay the loan off at closing from the down payment. That cash is money you received in the year of sale, so its share of gain is taxed in year one. See installment sale with a mortgage.
• Buyer assumes the loan with the lender's consent. The assumed balance up to your basis reduces the contract price; any excess over basis is a year-one payment (Temp. Reg. §15a.453-1(b)(3)(i)).
• Wraparound note. You keep paying your loan and the buyer pays you on a larger note. The lender can still call the loan. See wraparound mortgage and due-on-sale clause.

Tenants and leases

• Leases usually stay in place. A sale generally does not end existing leases; the buyer takes the property subject to them. Read each lease for sale or assignment terms.
• Security deposits. State law controls. In California, the landlord must either transfer the remaining deposits to the successor and notify the tenants, or return them to the tenants with an accounting (Civ. Code §1950.5).
• Rent rolls and estoppels. Provide a certified rent roll and tenant estoppels; as the lender, you want accurate income figures too.
• Your security depends on management you no longer control. Require insurance naming you, property tax impounds and the right to inspect. A poorly run building is worth less if you ever have to take it back. See when the buyer defaults.
• Rental rules for a financed buyer. A buyer purchasing a rental for business purposes is generally outside Regulation Z (12 CFR §1026.3(a)); if the buyer will live in one unit of a small multifamily, consumer rules may apply. See seller financing rules and Dodd-Frank.

Worked example: seller financing a rental

Simple example. You sell a fourplex for $1,200,000. You bought it for $700,000 ($200,000 land, $500,000 building) and have taken $250,000 of straight-line depreciation, so your adjusted basis is $450,000 and your gain is $750,000. No cost segregation, so there is no §1245 recapture; all $250,000 of depreciation is unrecaptured §1250 gain. The property is free and clear. Ignore selling costs for simplicity. You carry $150,000 of suspended passive losses. The buyer pays $240,000 down (20%) and signs a $960,000 note at 7%, with equal principal payments of $96,000 a year for 10 years and interest on the declining balance, paid annually.

Gross profit ratio: $750,000 gross profit ÷ $1,200,000 contract price = 62.5%.

What the table shows:

• The §1250 layer is front-loaded. The first $250,000 of recognized gain is unrecaptured §1250 gain (Reg. §1.453-12), so year one and part of year two carry the up-to-25% layer.
• Losses follow the gain. Year one recognizes $210,000 of $750,000, or 28%, so 28% of the $150,000 is released: $42,000. Each later year recognizes 8% and releases $12,000 (§469(g)(3)).
• Interest is a second income stream. $369,600 over ten years, ordinary income, and for most owners net investment income.
• If the fourplex had a cost segregation study with, say, $60,000 of §1245 recapture, that $60,000 would be ordinary income in year one on top of the table, whatever the buyer paid that year (§453(i)).
• If the buyer refinanced in year 3, the remaining $768,000 of principal would arrive that year, bringing $480,000 of gain and the remaining $96,000 of suspended losses into year 3 with it.

Model your own building, with your brackets and state, in the seller financing calculator, and see the payment schedule in the owner financing calculator.

Matching stuck losses without carrying the note

For rental owners, the tax case for installment treatment is often about more than brackets. Suspended passive losses come out in step with the gain, so a schedule that recognizes gain steadily lets those losses offset it year by year. A seller note makes that schedule depend on the buyer: a refinance, a resale or a default rewrites it. A structured installment sale keeps the schedule and removes the buyer.

The buyer pays the full price at closing, typically with a normal bank loan, which also means your existing mortgage is paid off cleanly. You receive payments from an assignment company on a schedule you choose before closing, and the gain is reported on the installment method (§453). No tenant-management risk behind your payments, no foreclosure, no servicing, and no early payoff that dumps the deferred gain, and the rest of your suspended losses, into one year. Matching a payment schedule to stuck passive losses is the subject of The Waterfall Strategy.

Seller financing still fits some rental sales: a buyer you know, such as a long-time tenant or a neighboring owner, a large down payment, a building a bank will not lend on, or a deal where you want room to renegotiate. When the buyer can get a bank loan, compare both.

What to know before you choose it. It has to be set up before closing; a note you already hold cannot be converted. The payments are locked in: you can't speed them up, borrow against them, pledge them or cash them out, and that is what keeps the deferral intact. There is no free look after closing: once the sale closes, the structure cannot be undone. The payments depend on the assignment company's ability to pay. The structure rests on settled installment-sale law, but this specific assignment structure has no published IRS ruling, so have your CPA or tax attorney review the documents. A commission is built into the pricing: Hans is paid about 2.4% of the amount structured, only if a structured sale is funded; seller financing pays him nothing (see the disclosures).

Use the seller financing calculator to compare your note with the same schedule paid by a structured sale. The full side-by-side is in seller financing vs structured sale.

Bottom line

Seller financing a rental spreads most of the gain over the years you are paid, but not all of it: cost-segregation and other ordinary recapture is taxed in year one, the unrecaptured §1250 layer comes out of the first payments, and a loan payoff at closing adds to year one. Suspended passive losses are released in step with the gain, which is a real advantage if the schedule holds. Plan the existing mortgage, the tenant handoff and your protections as a lender before you sign.

Questions to ask your CPA

• How much of my depreciation is §1245 recapture (from cost segregation or bonus) that will be taxed in year one?
• How much unrecaptured §1250 gain do I have, and in which years will it be recognized?
• Is this building my entire interest in the activity for §469(g), or is it grouped with other rentals?
• How much of my suspended losses will be released each year, and what will they offset?
• Will the gain and interest be subject to the 3.8% NIIT, and do I qualify for any real estate professional exception?
• Will my installment notes exceed $5,000,000 at any year end (§453A)?
• If the buyer refinanced in year three, what would that year's tax look like?

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.