How installment sales work when transferring real estate to family
Transferring property to family members using an installment sale means the seller acts as the lender: the buyer signs a promissory note, makes scheduled payments (principal plus interest), and the seller reports gain as payments arrive. This technique can smooth cash flow for both parties, defer capital gains tax for the seller, and allow a family member to acquire real estate without a large down payment.
In my practice working with family estates and real estate owners, I’ve seen installment sales succeed when the paperwork, tax reporting, and lender permissions are handled up front. When those elements are missed, disputes, imputed interest, gift-tax exposure, or mortgage acceleration problems are common.
Below I cover how an installment sale works step-by-step, the tax reporting rules you must know, practical drafting and legal issues, common mistakes, and a sample calculation to illustrate the tax timing benefits.
Step-by-step: structuring an intra-family installment sale
- Determine fair market value (FMV) and sale price. Use an independent appraisal to document FMV and support the sales price in case of IRS or family disputes.
- Decide whether the sale price equals FMV or is discounted. If discounted, the difference between FMV and sale price may be treated as a gift and could need Form 709 (gift tax return).
- Draft a written purchase agreement and promissory note. Include purchase price, interest rate, amortization schedule, security instrument (mortgage or deed of trust), acceleration clauses, and remedies for default.
- Set an interest rate at or above the published Applicable Federal Rate (AFR) to avoid imputed interest rules under IRC §7872. The AFR changes monthly; verify the current AFR at the time of the sale on the IRS site (Applicable Federal Rates).
- Verify existing lender terms. A mortgage with a due-on-sale clause can be triggered by a transfer; get lender consent or arrange an assumption or pay off the existing loan.
- Close the transfer with a deed and properly record it. Establish whether title transfer or retained title with conditional sale is appropriate for your state and tax goals.
- File required tax forms: sellers generally report installment sales on IRS Form 6252 and allocate receipts between interest (taxed as ordinary income) and principal (capital gain) each year.
Authoritative sources: see the IRS guidance on “Installment Sales” and instructions for Form 6252 for current reporting rules (IRS — Installment Sales; IRS Form 6252 instructions).
Key tax rules to know (U.S., federal)
- Installment-sale reporting under IRC §453 allows taxpayers to report gain as payments are received rather than all in the year of sale. This can smooth or defer capital gains tax liability.
- Certain gain components are not deferrable. Notably, gain attributable to depreciation recapture (and other statutorily excepted items) generally must be reported in the year of sale and cannot be deferred under the installment method. See Form 6252 instructions for details.
- Interest paid by the buyer is taxed to the seller as ordinary income; the principal portion produces capital gain up to the seller’s realized gain.
- If you sell below FMV to a family member, the discount can create a reportable gift. The seller may need to file IRS Form 709 (gift tax return) even if no gift tax is due.
- Parties should be careful with below-market loans. Under IRC §7872, the IRS may impute interest on loans with rates below the AFR, creating taxable income to the seller and a potential gift.
For current details, consult IRS pages on Installment Sales, Form 6252, and the Applicable Federal Rates.
Practical drafting, legal, and financing issues
-
Promissory note and security: A clear promissory note and recorded security interest protect both parties. The note should set payment dates, late fees, prepayment rights, and default remedies. In my practice I require a detailed amortization schedule and a personally signed security instrument recorded in county records.
-
Due-on-sale clauses: Many mortgages contain an acceleration (due-on-sale) clause. If a property has an existing mortgage, the lender may demand full repayment when title transfers. Avoid surprises by asking the lender for consent or structuring the transaction as an assumption if allowed.
-
State transfer taxes and recording fees: Transferring property may trigger state or local transfer taxes or reassessment of property taxes. Check local law before closing.
-
Estate and basis consequences: Selling property during life means the buyer’s tax basis equals the purchase price (not the seller’s stepped-up basis that would apply on inheritance). That affects future capital gains when the buyer sells the property. Conversely, gifting can reduce estate tax exposure but changes basis rules for the recipient.
-
Insurance and maintenance: Ensure the buyer maintains adequate hazard and liability insurance and that responsibilities for upkeep are documented in the sale agreement.
Sample, simplified tax illustration
Assume a seller sells a rental property with an adjusted basis of $100,000 and FMV of $300,000 to a child for $300,000 on a 10-year installment note with equal annual principal-and-interest payments. The seller will: (a) recognize depreciation recapture in the year of sale to the extent required by law, (b) report interest income each year, and (c) allocate principal payments between return of basis and capital gain and report the capital gain portion on Form 6252 as payments arrive.
This illustration is simplified; you should work with a tax preparer to calculate depreciation recapture, the gross profit percentage, and the annual taxable amounts reported on Form 6252.
Common mistakes and how to avoid them
- Failing to document FMV and terms. Solution: get an appraisal and a written agreement.
- Setting an interest rate below AFR. Solution: check the monthly AFR and set the rate at or above it to avoid imputed interest or unintended gift treatment.
- Ignoring lender consent. Solution: contact your mortgage lender early and get written confirmation about any assumption or payoff requirements.
- Forgetting to file Form 6252. Solution: sellers must file Form 6252 in the year of sale and for years when installment payments are received.
- Treating an installment sale like a gift. Solution: decide whether you intend a sale, a gift, or a hybrid; get tax advice and file Form 709 if necessary.
When an installment sale is a good fit
- You want to keep the property in the family but also receive income over time.
- The buyer has limited cash but can make steady payments.
- The seller wishes to defer capital gains into future years rather than recognize a large gain in one tax year.
When it may not be a good fit: you need full sale proceeds immediately, the property has significant depreciation recapture that would be taxed upfront, or existing financing makes a sale impractical.
Additional resources and internal links
- For differences between installment-style arrangements and IRS payment plans, see how the IRS calculates installment agreement payments on the site: “How the IRS Calculates Installment Agreement Payment Amounts” (https://finhelp.io/glossary/how-the-irs-calculates-installment-agreement-payment-amounts/).
- For eligibility and costs associated with IRS collection installment agreements (a different but related concept), see “Qualifying for an IRS Installment Agreement: Eligibility, Costs, and Application Tips” (https://finhelp.io/glossary/qualifying-for-an-irs-installment-agreement-eligibility-costs-and-application-tips/).
Professional tips
- Use a neutral appraiser and keep the report with the closing file.
- Have attorneys draft or review the purchase agreement, promissory note, and security instrument.
- Coordinate tax, estate, and real estate advisors so the sale accomplishes the family’s long-term planning goals.
- Consider a buy-sell or co-ownership arrangement if the buyer cannot qualify for full financing but will share ownership.
FAQs (brief)
Q: Can the seller accelerate the mortgage if the buyer defaults? A: If the note provides for acceleration and the security instrument was recorded, the seller can pursue remedies up to foreclosure, subject to state law.
Q: Does the seller pay capital gains tax immediately? A: Not necessarily—using the installment method, capital gain is reported as principal payments are received, although depreciation recapture and certain other items may be taxable in the year of sale.
Q: Is interest deductible to the buyer? A: Interest may be deductible if the buyer uses the property as a rental or if the note meets mortgage interest rules for personal residences — consult your tax advisor.
Professional disclaimer: This article provides general information and educational guidance only; it is not legal or tax advice. For personalized recommendations, consult a qualified tax professional, estate attorney, or real estate attorney familiar with federal and state rules (IRS publications on installment sales and Form 6252 are useful starting points).
Authoritative sources: IRS — “Installment Sales” and Form 6252 instructions; IRS — Applicable Federal Rates. Always review current IRS guidance and consult professionals before completing an intra-family installment sale.
