Each payment on an installment sale usually consists of the following three parts.

1. Interest income.
2. Return of your adjusted basis in the property.
3. Gain on the sale.

In each year you receive a payment, include the interest part in income, as well as the part that is your gain on the sale. You do not include in income the part that is the return of your adjusted basis in the property.

Interest income. You must report interest as ordinary income. Interest is generally not included in a down payment. However, you may have to treat part of each later payment as interest, even if it is not called interest in your agreement with the buyer. See Unstated interest, later.

Return of basis and gain on sale. The rest of each payment is treated as if it were made up of two parts. One part is a tax-free return of your adjusted basis. The other part is your gain.

Figuring gain part of payment. To figure what part of any payment is gain, multiply the payment (less interest) by the gross profit percentage, defined later. Use the following worksheet to figure the gross profit percentage.

1)	Selling price
2)	Installment sale basis:
	Adjusted basis of property
	Selling expenses
	Depreciation recapture
3)	Gross profit (line 1 - line 2)
4)	Contract price
5)	Gross profit percentage (line 3 × line 4)

Selling price. The selling price is the total cost of the property to the buyer. It includes any money and the fair market value of any property you are to receive. It also includes any debt the buyer pays, assumes, or takes, to which the property is subject. The debt could be a note, mortgage, or any other liability, such as a lien, accrued interest, or taxes owed on the property. If the buyer pays any of your selling expenses, that amount is also included in the selling price. The selling price does not include interest, whether stated or unstated.

Installment sale basis. Three items comprise installment sale basis.

• Adjusted basis
• Selling expenses
• Depreciation recapture

Adjusted basis. Basis is the amount of your investment in the property for tax purposes. The way you figure basis depends on how you first acquired the property. The basis of property you bought is generally its cost. The basis of property you inherited, received as a gift, built yourself, or received in a tax-free exchange is figured differently. See chapter 7 for information on determining basis.

While you own personal-use property, various events may change your original basis. Some events, such as adding rooms or making permanent improvements, increase basis. Others, such as deductible casualty losses or depreciation previously allowed or allowable, decrease basis. The result is adjusted basis.

Selling expenses. Selling expenses are any expenses that relate to the sale of the property. They include commissions and attorney fees. Selling expenses are added to the basis of the sold property.

Depreciation recapture. If you took depreciation deductions on the asset, you may need to recapture part of the gain on the sale of the asset as ordinary income. See Sale of depreciable property, later.

Gross profit. Gross profit is the total gain you report on the installment method.

To figure your gross profit, subtract your installment sale basis from the selling price. If the property you sold was your home, subtract from the gross profit any gain you can exclude. See Publication 523 for information on excluding gain on the sale of your home.

Contract price. The contract price is the total of all principal payments you are to receive on the installment sale. It also includes payments you are considered to receive. See Payments Received, later.

If part of the selling price is paid in cash and you hold a mortgage payable from the buyer to you for the remainder, then the contract price includes both. The selling price is the total cost of the property to the buyer.

Gross profit percentage. A certain percentage of each payment (after subtracting interest) is reported as gain from the sale. It is called the "gross profit percentage" and is figured by dividing your gross profit by the contract price.

The gross profit percentage generally remains the same for each payment you receive. However, see Selling price reduced, later, for an example of changing the gross profit percentage.

Example. You sell property at a contract price of $200,000 and your gross profit is $50,000. Your gross profit percentage is 25% ($50,000 × $200,000). After subtracting interest, you report 25% of each payment, including the down payment, as gain from the sale for the tax year you receive the payment.

Amount to include in income. Each year as you receive payments on the installment sale, multiply the payments (after subtracting interest) by the gross profit percentage to determine the amount you must include in income.

Sale of depreciable property. You cannot use the installment method to report any depreciation recapture income. However, report any gain greater than the recapture income on the installment method.

The recapture income reported in the year of sale is added to the property's adjusted basis to determine your gross profit on the installment sale.

You generally cannot report gain from the sale of depreciable property to a related person on the installment method. See Sale to a Related Person in Publication 537.

Figure your depreciation recapture income (including the section 179 deduction and the section 179A deduction recapture) in Part III of Form 4797. Report the depreciation recapture income in Part II of Form 4797 as ordinary income in the year of sale.

If you sell depreciable business property, prepare Form 4797 first in order to figure the amount to enter on line 12 of Part I, Form 6252. See the Form 6252 instructions for details.

For more information on the section 179 deduction, see Section 179 Deduction in chapter 8. For more information on the section 179A deductions, see chapter 12 in Publication 535. For more information on depreciation recapture, see Depreciation Recapture in chapter 11.

Selling price reduced. If the selling price is reduced at a later date, the gross profit on the sale will also change. You must then refigure the gross profit percentage for the remaining payments. Refigure your gross profit using the reduced sale price and then subtract the gain already reported. Spread the remaining gain over the future installments.

Example. In 1999, you sold land with a basis of $40,000 for $100,000. Your gross profit was $60,000. You received a $20,000 down payment and the buyer's note for $80,000. The note provides for four annual payments of $20,000 each, plus 12% interest, beginning in 2000. Your gross profit percentage is 60%. You reported a gain of $12,000 on each payment received in 1999 and 2000. In 2001, you and the buyer agreed to reduce the purchase price to $85,000 and the payments for 2001, 2002, and 2003 are reduced to $15,000 for each year.

The new gross profit percentage, 46.67%, is figured as follows.

1)	Reduced selling price		$85,000
2)	Minus: Basis		40,000
3)	Adjusted gross profit		$45,000
4)	Minus: Gain reported in 1999 & 2000		24,000
5)	Gain to be reported		$21,000
6)	Selling price to be received:
	Reduced selling price	$85,000
	Minus: Payments received in 1999 and 2000	40,000	$45,000
7)	New gross profit percentage (line 5 × line 6)		46.67%

You will report a gain of $7,000 (46.67% of $15,000) on each of the $15,000 installments due in 2001, 2002, and 2003.

Sale to a related person. Special rules apply to installment sales between related persons. For purposes of these rules, spouses, children, grandchildren, brothers, sisters, and parents are all considered related persons. A partnership or corporation in which you have an interest, or an estate or trust with which you have a connection, can also be considered a related person.

For information on these rules, see the instructions for Form 6252 and Sale to a Related Person in Publication 537.

Trading property for like-kind property. If you trade business or investment property solely for the same kind of property to be held as business or investment property, you can postpone reporting the gain. See Like-Kind Exchanges in chapter 10 for a discussion of like-kind property.

If the trade includes an installment obligation, the following rules apply.

1. The contract price is reduced by the FMV of the like-kind property received in the trade.
2. The gross profit is reduced by any gain on the trade that can be postponed.
3. Like-kind property received in the trade is not considered payment on the installment obligation.

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