Home / Articles

Seller Financing Taxes: How an Owner-Financed Sale Is Taxed

By Hans Goldstein · Updated 2026-09-27

When you seller-finance a sale, the IRS taxes it as an installment sale under IRC Section 453. The gain is taxed as the buyer pays you principal, a fixed percentage of each dollar, and the interest is taxed as ordinary income each year. Two things are not spread out: depreciation recapture on equipment and cost-segregated parts, and any loan of yours paid off at closing, both taxed in the year of sale.

That is the short answer. The rest of this guide shows how seller financing works from the seller's side, walks a $1.2 million rental sale through ten years of tax, and covers what is not deferred, the interest rate floor, the risks, and the forms. To run your own numbers, use the seller financing calculator.

How seller financing works in 60 seconds (seller side)

With seller financing (also called owner financing), you act as the bank:

1. The buyer pays you a down payment at closing.
2. The buyer signs a promissory note to you for the rest of the price, with interest.
3. The note is secured by a deed of trust or mortgage on the property you sold (or, in a land contract, you keep legal title until the buyer pays).
4. The buyer makes payments of principal and interest for years, often with a balloon payment at the end (see a worked seller financing example and how a balloon payment is taxed).
5. If the buyer stops paying, you can foreclose.

If a bank lends most of the price and you carry only a slice behind it, that is a seller carry back. The tax rules are the same; the risk and the amount deferred are very different.

How the IRS taxes seller financing

Every payment you receive is split into up to three parts (IRS Pub. 537):

The split between basis and gain is the gross profit percentage: gross profit divided by contract price. Gross profit is the selling price minus your adjusted basis, selling expenses and any year-one recapture. With no debt assumed by the buyer, the contract price is the selling price. Multiply each year's principal by the percentage, and that is your taxable gain for the year. The percentage stays the same for the life of the note. (How to compute it with debt and recapture: gross profit percentage.)

Character does not change. The character of the gain is fixed in the year of sale: a long-term gain stays long-term in every later year, and gain that was passive (or subject to the 3.8% NIIT) in the year of sale keeps that character as it is collected (Temp. Reg. §1.469-2T(c)(2)(i)(A); Reg. §1.1411-4(d)). The installment method moves the timing, not the kind of gain.

Worked example: $1.2 million rental, 20% down, 10-year note

Simple example, all numbers illustrative. A married couple, still working, sells a rental building.

• Price $1,200,000. No existing loan.
• Original cost $800,000. Straight-line depreciation taken $300,000. Adjusted basis $500,000.
• Selling expenses $60,000.
• Buyer pays $240,000 down (20%) and signs a $960,000 note: $96,000 of principal a year for 10 years, starting the year after the sale, plus 6% interest on the unpaid balance. (6% is a round number for the math, not a quote. The note must meet the AFR test.)
• The couple has $150,000 of other ordinary income a year, files jointly, takes the standard deduction, and 2026 federal brackets hold flat (Rev. Proc. 2025-32).

Step 1: the percentage. Installment basis = $500,000 + $60,000 = $560,000. Gross profit = $1,200,000 - $560,000 = $640,000. Gross profit percentage = $640,000 / $1,200,000 = 53.33%.

Step 2: the layers. $300,000 of the gain is unrecaptured §1250 gain from depreciation, taxed at no more than 25%, and it comes out of the earliest payments first (Reg. §1.453-12). The remaining $340,000 is long-term capital gain.

Step 3: tax by year. "Federal tax on the gain" is the extra federal income tax and 3.8% net investment income tax (NIIT) the gain causes, on top of the couple's other income and that year's interest.

The same sale for cash: all $640,000 lands in year one. Federal income tax on the gain is $127,763, plus $20,520 of NIIT, for $148,283.

Seller financing lowers the total by about $29,000 in this example (nominal dollars). Three things drive it:

• The 3.8% tax almost disappears. Spread out, only the first three years cross the $250,000 modified AGI line, and only barely: about $1,500 of NIIT in total instead of $20,520.
• No gain reaches the 20% bracket. In the cash sale, $129,850 of the long-term gain is stacked above $613,700 of taxable income and taxed at 20%. Spread out, all of it is taxed at 15%.
• The §1250 layer is taxed at 22% and 24%, below its 25% cap. In the cash sale, part of it reaches the 25% cap.

A retired couple with less other income would save more, because some of the gain would fall in the 0% bracket. The saving depends on your other income, which is why you run your own numbers.

What this table does not show: the $316,800 of interest, taxed as ordinary income; the risk the buyer pays late, defaults or pays off early; and the time value of receiving your money over 11 years.

What is NOT deferred

Seller financing spreads the gain, but not all of it. These land in the year of sale no matter how the note is written:

§1245 recapture (and §1250 additional depreciation). Depreciation on equipment, appliances, and cost-segregated 5- and 7-year building parts (§1245 property) is recaptured as ordinary income. So is depreciation beyond straight line, including bonus, on 15-year land improvements such as paving, fencing and landscaping: those are §1250 property, but the excess is ordinary recapture under §1250(a). Both are "recapture income" recognized in full in the year of sale, measured as if all payments had been received (§453(i)). A seller who took large cost segregation deductions can owe ordinary tax on that recapture in year one while collecting little cash. It is added to basis, so it is not taxed again later. See installment sale depreciation recapture.

A loan paid off at closing. If the buyer's money pays off your mortgage at closing, that cash is a payment to you in year one. Only debt the buyer assumes or takes the property subject to is left out, and only up to your basis (Temp. Reg. §15a.453-1(b)(3)(i)). On a property with a big loan, this can push most of the gain into year one. See installment sales with a mortgage.

Assumed debt above your basis. If the buyer assumes a loan larger than your installment basis, the excess is a year-one payment, and your gross profit percentage becomes 100%. Cash-out refinancing before a sale is how most sellers get here.

Inventory and dealer property. Inventory and real estate held for sale to customers cannot use the installment method at all (§453(b)(2), (l)).

Interest. Interest is never part of the installment gain. It is ordinary income each year.

The minimum interest rate (AFR)

You and the buyer set the rate, but it must be at least the applicable federal rate (AFR) for the note's term: short-term for 3 years or less, mid-term for over 3 and up to 9 years, long-term for over 9 years (§1274(d)). If the note's rate is lower, part of each principal payment is treated as interest under §483 or §1274. That turns low-taxed capital gain into ordinary income, and in some cases you owe tax on interest before you receive it.

The IRS publishes the rates monthly on its applicable federal rates page. The test uses the lowest rate in the three months ending with the month you sign a binding contract (§1274(d)(2)). Full detail: seller financing interest rate and the AFR.

For a rental seller, the interest is portfolio income. Suspended passive losses cannot offset it (Temp. Reg. §1.469-2T(c)(3)). It also counts toward the NIIT.

Pros and cons for the seller

For a decision checklist and a cash-versus-note example, see is seller financing a good idea?

The upside:

• Settled law. A seller holding the buyer's own note, secured by the property, is the textbook installment sale.
• Tax spreading. Smaller slices of gain can land in lower brackets and stay under the NIIT line.
• Interest income. You earn the note rate on the unpaid balance.
• Real collateral. The note is secured by the property.
• More buyers. A buyer who cannot get a full bank loan may pay your price with your financing.
• No commission to anyone for the financing.
• Flexibility. You can renegotiate, or sell the note later (which triggers the remaining tax).

The downside:

• Default. Foreclosure takes months, a bankruptcy filing freezes it (11 U.S.C. §362), and some states limit what you can collect; in California, a seller who carries back the price generally cannot get a deficiency judgment (Code Civ. Proc. §580b).
• Repossession tax. If you take real property back, §1038 can tax part of what you already collected, and the plan is over.
• Early payoff. If the buyer refinances or sells, you get the rest of your money and the rest of the gain is taxed that year. A due-on-sale clause usually forces this when the buyer resells.
• No cash-out without tax. Selling the note is a disposition (§453B), and borrowing against it is treated as a payment for sales over $150,000 (§453A(d)).
• You are the servicer. Collecting, tracking insurance and taxes, year-end statements, for years.
• Big notes. If more than $5 million of installment notes from the year's sales are outstanding at year end, §453A adds an interest charge on the deferred tax attributable to the excess. Farm and personal-use property are exempt.
• Consumer lending rules. Selling a home to someone who will live in it can bring federal and state lending rules into play. Ask a real estate attorney, and see seller financing a home.

What each of those events does to your tax: buyer defaulted or paid early. How to write terms that protect you: seller financing note terms.

Seller financing vs a structured installment sale

If the buyer's credit is the part you do not want to hold, there is a second way to use the same §453 rules. In a structured installment sale, the buyer pays the full price at closing, and an assignment company pays you on a schedule fixed before closing, usually funded by a fixed annuity the assignment company owns (some programs use a funding agreement).

Both carry risk. One puts the buyer's credit and behavior on you; the other substitutes a financial company's credit and an open legal question. Full comparison: seller financing vs a structured sale.

Seller financing a business, real estate or land

The same §453 rules apply to all three, but the traps differ.

• Real estate (rentals, commercial). Watch §1245 recapture from cost segregation, the 25% layer that comes out first, and any loan paid off at closing. Rental owners with suspended passive losses can time installment gain to meet them.
• A business. Inventory cannot use the installment method, equipment recapture is taxed in year one, and the price allocation you sign (Form 8594) decides how much can be deferred. See seller financing a business sale.
• Land. Raw land has no depreciation, so no recapture; nearly all the gain can ride the note. Farm property is exempt from the §453A interest charge. See selling land on owner financing.

Reporting: Form 6252, interest and statements

Form 6252. File it for the year of sale and every year after until the final payment, even in a year with no payment. It computes the gross profit percentage and each year's gain, which flows to Form 4797 (rental or business property) or Schedule D (capital assets). Walkthrough: Form 6252 instructions.

Form 4797, Part III. Figures any depreciation recapture, taxed in year one.

Interest. Reported as interest income, generally on Schedule B. If you sold a home to a buyer who lives in it, list the buyer's name, address and SSN on Schedule B, line 1; the buyer lists yours to deduct the interest, and a penalty applies if either of you leaves the other's SSN off (Pub. 537).

Form 1098. The instructions for Form 1098 require it only from someone who receives $600 or more of mortgage interest in the course of a trade or business. They give the example of a seller holding the mortgage on a former personal residence, who is not required to file it. A developer financing lots in a subdivision would be. Ask your CPA which side you are on.

Estimated tax. Each year's gain and interest raise your tax. Plan estimated payments for every year of the note, not just the year of sale.

State returns. States tax the gain on their own schedule. California taxes capital gain as ordinary income and taxes gain on California property even after you move away.

The interest you collect is reported separately from the gain; see how to report seller financing interest income.

Bottom line

Seller financing is an installment sale: gain is taxed as principal arrives, at one fixed percentage, and interest is taxed as ordinary income every year. It can lower the total tax on a large gain by keeping each year's slice in lower brackets and under the 3.8% line. It does not defer §1245 recapture or a loan paid off at closing, and it makes you the lender, with the buyer's default and early-payoff risk. Run your numbers in the calculator with your real basis, depreciation and loan, then take them to your CPA.

Questions to ask your CPA

• What is my adjusted basis, including improvements and all depreciation?
• How much §1245 recapture is in this sale, and what is the year-one tax on it?
• Will my loan be paid off at closing or assumed, and how does that change year one?
• What gross profit percentage will Form 6252 show?
• Given my other income, what principal payment each year keeps the gain in the 15% bracket or lower and under the NIIT line?
• What AFR applies to this note, and is our rate above it?
• If the buyer pays off early, defaults, or I sell the note, what is my tax that year?
• How does my state tax the gain and the interest?

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.