How does an installment sale spread capital gains tax?

The short answer

An installment sale spreads capital gains tax by letting the seller report the gain as payments arrive instead of all in the year of closing. Each principal payment is part tax-free return of basis and part taxable gain, so a sale paid over five years can be taxed across six tax years.

Spreading the gain can keep more of it in the 15 percent bracket and below the 3.8 percent tax threshold each year. The trade is that the seller becomes the buyer's lender, and a note over $5 million can add an interest charge on the deferred tax.

How does the installment method work?

IRS Publication 537 defines an installment sale as a sale of property where you receive at least one payment after the tax year of the sale. When a sale qualifies, Section 453 applies the installment method automatically unless you elect out.

The math rests on three numbers:

1. Gross profit. The selling price minus your adjusted basis, selling expenses and any depreciation recapture. This is the total gain reported over the life of the sale.
2. Contract price. Generally the selling price, less certain debts the buyer takes over. In a cash free, debt free sale it is usually the selling price.
3. Gross profit percentage. Gross profit divided by contract price. This percentage of every principal payment, including the closing payment, is taxable gain. The rest is a tax-free return of basis.

Interest on the buyer's note is separate. It is ordinary income, and if the note charges too little interest, part of the principal can be recharacterized as interest under the test rate rules in Publication 537. The sale is reported on Form 6252 for the year of sale and every later year until the last payment arrives.

The method changes when gain is reported, not its character or its total.

Marcus's sale at closing vs over five years: a hypothetical example

Here is a hypothetical example. It is an illustration, not a projection, and your numbers can differ.

Example: Marcus, 63, married filing jointly, sells all of the stock of his family's distribution company in Raleigh for a hypothetical $8,000,000. His basis in the stock is $800,000, so his gain is $7,200,000 and his gross profit percentage is 90 percent. The company is a C corporation and we assume the stock does not qualify for the Section 1202 exclusion, so the whole gain is long term capital gain and net investment income. Marcus and his spouse have $200,000 of other taxable income each year. To keep the math visible, we treat taxable income and modified adjusted gross income as the same, hold 2026 rates and thresholds flat for every year, and leave out the interest he earns on the note.

He compares two versions. In the first, the buyer pays all $8,000,000 at closing in 2026. In the second, the buyer pays $2,000,000 at closing and gives him a $6,000,000 note paid in five annual installments of $1,200,000 from 2027 through 2031, plus interest.

For 2026, the IRS taxes long term gain for joint filers at 15 percent above $98,900 and at 20 percent above $613,700 of taxable income. Because Marcus's other income already fills the first $200,000, $413,700 of gain fits in the 15 percent band each year. The 3.8 percent tax applies to the lesser of net investment income or the amount by which modified adjusted gross income exceeds $250,000. For an owner who materially participates in an S corporation, part or all of the gain may fall outside that tax under Section 1411.

In this example, the all cash sale costs $1,691,015 in federal tax, all due for 2026. The installment version costs $1,578,090 spread over six years, or $112,925 less. Most of the gap, $103,425, comes from using the 15 percent band five more times. The other $9,500 comes from the 3.8 percent tax threshold. Marcus also keeps about $1,285,000 of tax unpaid in 2026 that he would otherwise owe for the year of closing.

Two caveats matter. Interest on the note is ordinary income that fills part of the 15 percent band each year, so the real benefit can be smaller than the table shows. And gain reported in 2027 through 2031 is taxed at the rates in effect then, which can be higher or lower than 2026.

North Carolina taxes capital gains as ordinary income at a flat rate, 3.99 percent for tax years after 2025, according to the North Carolina Department of Revenue. With a flat rate there is no bracket to manage, so spreading the gain mostly changes when Marcus owes about $287,280 of state tax, not how much. The Department notes that rate reduction triggers may change rates for 2027 and later.

You can run your own price and basis in the business sale calculator.

What is the interest charge on notes over $5 million?

Section 453A adds a cost to large deferrals. For property sold for more than $150,000, if the face amount of installment notes that arose during the year and are still outstanding at year end exceeds $5,000,000, the seller pays interest on part of the deferred tax. Form 6252 instructions repeat the same two tests.

The charge equals three numbers multiplied together:

• The applicable percentage: the face amount over $5,000,000 divided by the total face amount.
• The deferred tax liability: the gain not yet reported at year end times the maximum capital gains rate, 20 percent.
• The IRS underpayment rate for the month the tax year ends. The IRS set it at 7 percent for October through December 2026, and it resets every quarter.

For Marcus, the applicable percentage is $1,000,000 divided by $6,000,000, or one sixth. At the end of 2026, $5,400,000 of gain is unreported, so the deferred tax liability is $1,080,000. The 2026 charge is one sixth of $1,080,000 times 7 percent, or $12,600. The charge continues each year the note is outstanding. If the rate stayed at 7 percent, which it may not, the charges through 2030 would total about $37,800, which would cut his $112,925 difference to about $75,125 in this example.

A note at or under $5,000,000 would not trigger the charge, which is why the size of a seller note is often a negotiated number. Section 453A also has a pledge rule: if you borrow against the note, the loan proceeds can be treated as a payment received.

Which parts of a business sale cannot be spread?

A business is not one asset for this purpose. Publication 537 says the price must be allocated across the assets, and some of them cannot use the installment method at all:

• Depreciation recapture. Under Section 453(i), ordinary income from recapture on equipment and other depreciable property is reported in full in the year of sale, even if no cash arrives that year. In an asset sale, this can create a tax bill larger than the closing payment.
• Inventory. Gain on inventory is reported in the year of sale.
• Publicly traded stock or securities. A sale of stock traded on an established market cannot use the method, and if the buyer pays you in readily tradable securities or a note payable on demand, that is treated as a payment when received.
• Sales at a loss. The installment method applies only to gains.

If the deal is structured as an asset sale, the recapture rules can shrink the share of gain that can be spread. Asset sale vs stock sale shows how much of a typical price can be recapture.

What are the risks of carrying a seller note?

The tax deferral comes bundled with a loan. A few risks belong in the discussion:

1. Credit risk. If the buyer's business struggles, the payments can stop. The seller is often a subordinated lender, behind the bank that financed the deal.
2. Rate risk. Gain reported in later years is taxed under the law in effect then.
3. Escrow and pledge traps. An irrevocable escrow that secures the remaining payments can end installment treatment, and borrowing against the note can be treated as a payment.
4. Related buyers. Selling to a family member or controlled entity has extra rules. If a related buyer resells within two years, you can be treated as receiving the resale proceeds.
5. Concentration. Until the note is paid, much of your net worth can still depend on one company.

None of these rules out an installment sale. They are reasons to price the note, its interest rate, its security and its size as carefully as the headline number, with your CPA and attorney testing the terms against your own facts.

The bottom line

An installment sale spreads capital gains tax by matching the gain you report to the cash you receive. For a seller in the top bracket, that can put more gain in the 15 percent band and below the 3.8 percent tax threshold, and it delays when the tax is due. In our hypothetical $8,000,000 sale, the difference was $112,925 of federal tax before a Section 453A interest charge of about $37,800. The cost is that you become a lender to the buyer, with the risks that come with it. If a sale is still years away, the exit planning timeline and how to value a business before a sale show what to settle first.

If a buyer offered you 25 percent at closing and the rest over five years, do you know what that note is worth to you after tax, interest and the risk that it is not paid?

For owner-focused planning next to a sale timeline, browse the business owner lessons or start with the free Retirement Reality Report.

Questions people ask next

Can I use the installment method if the buyer pays part of the price at closing?

Yes. An installment sale only requires at least one payment after the tax year of the sale. The closing payment is taxed in the year of sale using the same gross profit percentage that applies to every later principal payment.

Do I have to use the installment method?

No. If a sale qualifies, the installment method applies automatically unless you elect out. To elect out, you report the full gain on Form 8949, Form 4797 or both instead of Form 6252, by the due date of the return, including extensions, for the year of the sale.

What happens to an installment note if the seller dies?

According to IRS Publication 537, passing the note to an heir or estate at death is generally not a disposition. Whoever receives the note is taxed on the remaining payments the same way the seller would have been. Canceling the note at death, or transferring it to the buyer, is treated differently.

Does an earnout count as an installment sale?

An earnout is usually a contingent payment sale, because the total price is not known by the end of the year of sale. The installment method can still apply, but the IRS uses separate rules in Regulations section 15a.453-1(c) to figure basis recovery and the gross profit percentage.