IRS Rules on Land Contracts for Buyers and Sellers

The IRS rules on land contracts treat the deal as an immediate sale with seller-provided financing, even though the seller keeps legal title until the buyer finishes paying. The seller reports gain on the sale, usually spread across years under the installment method, and pays ordinary tax on interest received. The buyer is treated as the homeowner from day one and can deduct mortgage interest and property taxes just like anyone with a bank loan. Both sides have annual reporting to do for as long as the contract is in force.

Why the IRS Treats the Buyer as the Owner

The IRS looks past the deed and asks which party carries the “benefits and burdens” of the property. In almost every land contract, the buyer takes possession on day one, pays the property taxes and insurance, handles maintenance, and absorbs any drop in value. Those are the marks of ownership, so the IRS treats the buyer as the owner from the date the contract takes effect.

The result is straightforward. The transaction is taxed as a sale with a seller-financed loan, not as a rental. The seller is treated as having sold the property and received a promissory note. The buyer is treated as a homeowner who borrowed money from the seller. Every tax consequence flows from that framing.

How the Seller Is Taxed

Because payments come in over years, a land contract qualifies as an installment sale under Internal Revenue Code Section 453. An installment sale is any property disposition where at least one payment arrives after the tax year the sale closes.¹ The installment method spreads taxable gain across the years payments come in rather than dumping the whole gain into the year of sale. The seller’s income splits in two: capital gain on the sale itself, and ordinary interest income on the financing.

Gross Profit Percentage

Each principal payment contains a taxable portion and a nontaxable return of basis. The taxable share is set by the gross profit percentage, calculated by dividing the gross profit (selling price minus adjusted basis and selling expenses) by the total contract price.¹ That percentage stays fixed for the life of the contract.

Say you sell land on a $200,000 contract and your adjusted basis plus expenses is $120,000. Your gross profit is $80,000, and your gross profit percentage is 40%. For every $1,000 of principal you collect, $400 is taxable gain and $600 is a return of your investment. The seller calculates this each year on Form 6252 and carries the gain to Schedule D.²

Interest Income

Interest the seller collects is ordinary income, separate from the installment gain calculation. Most sellers report it on Schedule B of Form 1040 if it exceeds $1,500.³ If the property was investment or business property, the interest may instead land on Schedule E or Schedule C depending on the seller’s activity level.

Imputed Interest at the AFR

If the contract charges no interest, or less than the Applicable Federal Rate, the IRS rewrites the deal. Under Sections 483 and 1274, interest is imputed at the AFR, which shifts a portion of what the contract calls “principal” into “interest.”⁴ The seller ends up with more ordinary income and less capital gain. The buyer gets a bigger interest deduction to match. Writing a low rate into the contract does not avoid the rule. Current rates appear on the IRS Applicable Federal Rates page.⁵

Depreciation Recapture Comes Due Immediately

Sellers who claimed depreciation on the property face an extra hit. Section 453(i) requires all depreciation recapture income to be recognized in the year of sale, regardless of whether any cash has arrived.⁶ Recapture is taxed as ordinary income. Only gain above the recapture amount can be deferred under the installment method. Section 1250 governs how much recapture applies to real property that used accelerated depreciation.⁷ This catches many rental-property sellers off guard because they owe tax on recapture before the buyer has paid much of anything.

Home Sale Exclusion

Sellers who used the property as their primary residence for at least two of the five years before the sale can exclude up to $250,000 of gain ($500,000 for joint filers) under Section 121. The exclusion applies to installment sales. When it covers all the gain, the seller reports zero capital gain on Form 6252 each year while still reporting interest income as ordinary income.⁸ If gain exceeds the exclusion, apply the exclusion first, then use the installment method for the rest. Depreciation recapture (from a home office, for example) still hits in the year of sale and cannot be sheltered by Section 121.

How the Buyer Is Taxed

Because the IRS calls the buyer the economic owner from day one, the buyer gets the same tax benefits as a bank-financed homeowner. The two main deductions are mortgage interest and property taxes, both on Schedule A.

Mortgage Interest Deduction

The interest portion of each payment is deductible as qualified residence interest if the buyer itemizes. IRS Publication 936 specifically lists a land contract as a qualifying secured debt, provided the contract makes the buyer’s ownership security for repayment and treats the property as satisfying the debt in default.⁹ The deduction is capped at interest on the first $750,000 of acquisition debt ($375,000 if married filing separately) for contracts entered after December 15, 2017.¹⁰

There is a catch that trips up many buyers. No bank is involved, so there is no Form 1098 documenting interest paid. The buyer reports the interest on Schedule A, line 8b, and provides the seller’s name, address, and taxpayer identification number on the dotted lines next to that entry. Missing the seller’s TIN can trigger a $50 penalty.⁹ Both parties should exchange Form W-9 at or before closing.¹¹ If the seller refuses to hand over a TIN, claim the deduction anyway and attach a statement documenting your effort.

Property Tax Deduction

The buyer can deduct property taxes on the home, even when the contract calls for the seller to collect the money and remit it to the taxing authority. The state and local tax deduction is capped at $40,000 ($20,000 if married filing separately), with a phasedown for taxpayers with modified adjusted gross income above $500,000. At the highest income levels, the cap floors at $10,000.¹² These thresholds increase by 1% annually through 2029.

Buyer’s Basis

The buyer’s tax basis is the full purchase price stated in the contract plus qualifying closing costs. Interest paid over the life of the contract is not added to basis. Principal payments do not increase basis either, because they reduce the loan balance rather than the investment in the property. Capital improvements do increase basis and should be tracked, since basis drives taxable gain when the buyer eventually sells.

Annual Reporting for Both Sides

Land contracts generate ongoing paperwork because the IRS treats the deal as both a sale and a loan.

The seller files Form 6252 every year the installment obligation exists, even in years no payment is received. The form calculates recognized capital gain for that year, which flows to Schedule D.² Interest income is reported separately on Schedule B.¹³

Who issues what to whom is the part people most often get wrong. In a typical land contract between individuals, the seller is generally not required to issue Form 1099-INT for the interest received. The IRS exempts interest on obligations issued by individuals from 1099-INT reporting.¹⁴ The reporting burden shifts to the buyer, who identifies the seller by name, address, and TIN on Schedule A to claim the interest deduction. The seller still owes tax on the interest whether or not any information return was filed.

Family and Related-Party Sales

Selling to a relative on a land contract invites extra scrutiny, and two separate rules can apply.

The resale trigger rule comes first. If you sell to a related party on an installment basis and that person resells the property within two years, the second sale’s proceeds are treated as if you received them at the time of the resale.⁶ That accelerates gain and can wipe out the deferral. Related parties include spouses, children, grandchildren, parents, siblings, and certain controlled entities. The rule does not apply if neither sale was motivated by tax avoidance.

A stricter rule kicks in when the property is depreciable in the buyer’s hands and the buyer is a controlled entity (a business the seller owns more than 50% of). The installment method is flatly disallowed, and the seller recognizes all gain in the year of sale.⁶

Gift tax is the third landmine. When a family contract sets the price or interest rate below fair market value, the gap between what a third-party buyer would pay (including market-rate interest) and what the family member actually pays is a gift. If it exceeds the annual exclusion ($19,000 per recipient for 2025), the seller must file Form 709 even if no gift tax is owed thanks to the lifetime exemption. Combining a below-market price with a below-AFR rate can produce a surprisingly large gift that stacks year over year.

Default and Repossession

When a buyer stops paying and the seller takes the property back, Section 1038 controls. The rules are mandatory and usually more favorable than normal disposition rules.

The seller’s recognized gain is limited to the lesser of two amounts. The first is the total cash and value of other property received before repossession, minus any gain already reported in prior years. The second is the original gross profit, reduced by previously reported gain and by the seller’s repossession costs.¹⁵ The seller cannot claim a loss on repossession, and no bad debt deduction is available for the unpaid balance.

The defaulting buyer is treated as having disposed of the property in exchange for cancellation of the remaining debt. If canceled debt exceeds the buyer’s adjusted basis, the buyer has taxable gain. If the property was a personal residence and its value fell below basis, the resulting loss is generally not deductible under the personal-use property rules.

On the paperwork side, the seller may need to issue Form 1099-A to the buyer, reporting the outstanding principal and the fair market value of the property as of the repossession date.¹⁶ If the seller also cancels $600 or more of remaining debt, Form 1099-C may be required. When repossession and cancellation happen in the same calendar year, one Form 1099-C can cover both.

Balloon Payments, Payoffs, and Selling the Note

Many land contracts call for a balloon payment after several years of smaller installments, usually when the buyer refinances with a conventional lender. The balloon is treated exactly like any other principal payment: apply the gross profit percentage to figure the taxable portion and treat the rest as return of basis. There is no special rate or penalty for the lump sum. The seller reports it on Form 6252 for the year received. Early payoffs work the same way, and once the payoff is booked, the seller has no further installment reporting, though records should be kept in case of a later audit.

A seller who wants out sooner can sell or assign the note. Section 453B treats that as a taxable event. The seller recognizes gain or loss equal to the difference between the note’s tax basis and the amount realized.¹⁷ The note’s basis is its face value minus the income that would be reported if the buyer paid it in full, so the basis reflects the untaxed portion of the remaining balance. Any gain keeps the character of the original sale, so it stays long-term capital gain if the property was held more than a year before the contract was signed. Gifting the note to anyone other than a spouse triggers the same recognition, using the note’s fair market value as the amount realized. Transfers to a spouse or incident to divorce are generally nontaxable.

1
Office of the Law Revision Counsel. 26 U.S. Code 453 – Installment Method
2
Internal Revenue Service. Publication 537, Installment Sales
3
Internal Revenue Service. 1099-INT Interest Income
4
Office of the Law Revision Counsel. 26 U.S. Code 483 – Interest on Certain Deferred Payments
5
Internal Revenue Service. Applicable Federal Rates (AFRs) Rulings
6
Office of the Law Revision Counsel. 26 USC 453 – Installment Method
7
Office of the Law Revision Counsel. 26 U.S. Code 1250 – Gain From Dispositions of Certain Depreciable Realty
8
Internal Revenue Service. Publication 523, Selling Your Home
9
Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction
10
Internal Revenue Service. Real Estate (Taxes, Mortgage Interest, Points, Other Property Expenses)
11
Internal Revenue Service. About Form W-9, Request for Taxpayer Identification Number and Certification
12
Internal Revenue Service. Topic No. 503, Deductible Taxes
13
Internal Revenue Service. About Schedule B (Form 1040), Interest and Ordinary Dividends
14
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
15
Office of the Law Revision Counsel. 26 U.S. Code 1038 – Certain Reacquisitions of Real Property
16
Internal Revenue Service. Topic No. 432, Form 1099-A and Form 1099-C
17
Office of the Law Revision Counsel. 26 U.S. Code 453B – Gain or Loss on Disposition of Installment Obligations