How installment sale treatment works
When a seller finances the sale, they typically do not receive the full purchase price in year one — so the IRS lets them spread the capital gains tax over the life of the note via the installment method (IRC §453).
Each year the seller receives principal payments, a proportional share of the total gain is reported as capital gain. Interest received is taxed separately as ordinary income.
The seller's annual paperwork
Every January the seller has two filings on the buyer's behalf:
- Form 1098 — reports the mortgage interest the buyer paid during the year. Required if interest paid is $600+.
- Form 6252 — reports the seller's installment sale income for the year (filed with the seller's own return).
The buyer's deductions
Buyers in an owner-financed deal claim the exact same deductions as in a bank-financed purchase: mortgage interest (Schedule A), property tax (Schedule A), and any points paid at closing. The home must be your primary or secondary residence and the loan must be secured by the property (which means: deed of trust or mortgage recorded at the county — a contract-for-deed may complicate the deduction).
Applicable Federal Rate (AFR) — why it matters
If the loan's stated interest rate is below the IRS Applicable Federal Rate, the IRS will impute (assume) interest at the AFR and tax the seller on the difference. As of 2026 the long-term AFR sits around 4.5% — most owner-finance deals run well above this, so it is a non-issue in practice, but always check the current AFR before agreeing to a sub-5% rate.
Common mistakes that cause problems
- Failing to issue Form 1098 — the buyer cannot deduct interest the seller never reported.
- Treating the entire down payment as capital gain in year one — overpays tax up front.
- Using a sub-AFR interest rate without realizing the IRS will impute interest anyway.
- Forgetting state-level transfer tax — owed at closing regardless of who is financing.