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In an installment sale, the seller is financing the sale of his or her property. The buyer is required to make at least one payment in the year of sale, and makes periodic payments of principal and interest to the seller as agreed. In return, the seller earns interest and is not required to pay tax on the entire gain from the sale immediately. If at least one payment is received in the year of sale, the installment method of reporting the income can be used. Each year, the installment payments are partially subject to tax.

Let's look at an example to see how the payments are taxed.

Tom sells his rental property for $300,000. He decides to finance the sale of the property for the buyer at an interest rate of 6% for ten years and the rental property has an adjusted basis of $250,000. In year one of the sale, Tom receives payment in the amount of $31,800. This payment is broken down into three parts, and has the following tax implications:

Return of basis—not taxable	$25,000
Profit—taxable	$5,000
Interest on the "loan"—taxable	$1,800

As you can see, the profit on the sale is taxed as the payments are received. The gain portion of the installment payments in excess of recaptured depreciation is taxed at preferential capital gains rates.

SUGGESTION: Installment sales are reported on IRS Form 6252—Installment Sale Income.

IMPORTANT NOTE: The IRS requires that the seller charge an adequate amount of interest on the loan. To accomplish this, the interest rate must be at least equal to the Applicable Federal Rate (AFR) in effect at the time of sale. Contact your tax professional to obtain the AFR that will apply for you.

There is another complicated tax rule that applies to installment sales of rental real estate. It is called depreciation recapture. The IRS taxes the seller in the year of sale on the depreciation. The maximum tax rate applied to depreciation recapture is 25%. If this sounds like a foreign language to you, contact your tax professional to help you determine if this applies to you. If it does, make sure that the payment received in year one of the sale covers your tax bill.