Seller Financing Commercial Real Estate: Terms, Taxes and Risks
Seller financing commercial real estate means you act as the lender: the buyer pays part of the price at closing and signs a note to you for the rest, secured by the building. For a long-held, heavily depreciated property, that note can also spread the capital gain over the years you are paid under the installment method (IRC §453). Two parts of the gain do not spread the way owners expect: recapture on cost-segregated components is taxed in year one, and the building's depreciation (taxed at up to 25%) comes out of the first payments.
This guide covers why commercial sellers carry paper, the common structures, the terms to negotiate, how the gain is taxed year by year, and a worked $3 million example. Run your own numbers in the calculator.
Why commercial sellers carry paper
Owners of commercial property carry a note for three usual reasons:
- Low basis, big gain. A building owned for 20 years is often fully or mostly depreciated. Spreading the gain can keep more of it in lower brackets.
- Buyer financing gaps. Banks may lend less than the buyer needs on older buildings, special-use property or smaller deals. A seller note fills the gap and can support a higher price.
- Income. Some sellers want a monthly payment secured by a building they know, rather than a lump sum to reinvest.
The trade-off is that you are now a lender with one borrower and one piece of collateral. If the buyer stops paying, your remedy is foreclosure on a property you already sold. Treat the buyer like a bank would.
Common structures
| Structure | How it works | What to watch |
|---|---|---|
| Seller note in first position | You are the only lender, secured by a first deed of trust or mortgage | Cleanest security; you carry all the credit risk |
| Seller note behind a bank loan | Bank lends most of the price in first position; your note is a second | In default the bank is paid first; the bank may limit when you are paid |
| Seller carry-back with SBA or other senior lender | Common when the building is sold with an owner-occupied business | The senior lender sets its own rules on seller notes; get them in writing before you agree |
| Wraparound | Your existing loan stays in place and the buyer pays you on a larger note | Due-on-sale risk; special tax rules (see installment sale with a mortgage) |
| Structured installment sale | The buyer's obligation is assigned to a company that makes the payments, usually funded by a fixed annuity that company owns; some programs use a funding agreement | You are an unsecured creditor of that company, not secured by the building; the payment schedule is locked (no acceleration, pledging or changes); no IRS ruling specifically approves the structure; a commission is built into pricing |
For more on the seller-held second position, see seller carry back. For the objective comparison of carrying the note yourself versus a structured sale, see seller financing vs structured sale.
Terms to negotiate
| Term | What it controls | Practical point |
|---|---|---|
| Down payment | Your cushion and the buyer's commitment | More down means less risk and more year-one tax |
| Interest rate | Your ordinary income each year | Must be at least the applicable federal rate (AFR) for the term, or part of principal is recharacterized as interest (§§483, 1274) |
| Amortization and balloon | Payment size and when the balance is due | A 25 or 30-year amortization with a 5 to 10-year balloon is a common pattern; the balloon year can bunch gain |
| Security | What you can foreclose on | Deed of trust or mortgage, assignment of rents, UCC filing on personal property |
| Guaranties | Who else owes you | Personal guaranties from the buyer's principals |
| Covenants | Keeping the collateral whole | Insurance naming you, property tax proof, no further liens, financial reporting |
| Prepayment | When the note can be paid off | Payoff ends the deferral; the remaining gain is taxed that year |
| Default and cure | How fast you can act | Late fees, default interest, notice and cure periods |
How the gain is taxed
Commercial real estate usually has three layers of gain. The installment method treats each differently.
- Ordinary recapture on cost-segregated components: §1245 recapture on 5 and 7-year property, plus §1250 "additional depreciation" (anything beyond straight line, including bonus) on 15-year land improvements. Ordinary income, taxed in the year of sale in full, no matter how little cash you receive (§453(i)).
- Unrecaptured Section 1250 gain, the straight-line depreciation on the building. Ordinary rates capped at 25% (§1(h)(1)(E)). Deferred with the payments, but taken into account before the lower-rate capital gain (Reg. §1.453-12). The unrecaptured Section 1250 gain guide explains the 25% layer in detail.
- Section 1231 / long-term capital gain. 0%, 15% or 20%, as payments arrive.
Every principal payment carries the same gross profit percentage: gross profit divided by contract price. Recapture income is added to basis for this calculation so it is not taxed twice. Interest is ordinary income every year, separate from the gain. The mechanics are in the gross profit percentage guide.
Two more rules matter for larger commercial deals:
- Mortgage paid off at closing. Cash from the buyer used to pay off your loan at closing is treated as a payment to you in the year of sale. Only a loan the buyer actually assumes or takes subject to is excluded, and only up to your basis (Temp. Reg. §15a.453-1(b)(3)(i)).
- Section 453A. If more than $5 million of installment notes from the year's sales (each over $150,000) remain outstanding at year end, §453A charges interest on the deferred tax attributable to the excess. Borrowing against any such note, including pledging it, is treated as receiving payment (§453A(d)). See the 453A guide.
Worked example: $3 million building, 25% down
Simple example. Married filing jointly, $150,000 of other ordinary income each year, 2026 standard deduction and federal brackets held flat (Rev. Proc. 2025-32). Federal income tax only: no interest, no state tax, no 3.8% NIIT, no selling costs.
You sell a commercial building for $3,000,000. Your adjusted basis is $900,000 after $600,000 of depreciation: $100,000 on cost-segregated 5- and 7-year components (Section 1245) and $500,000 of straight-line building depreciation. No mortgage. The buyer pays $750,000 down and gives you a $2,250,000 note, with principal of $225,000 a year for ten years.
Step 1: the gain. $3,000,000 - $900,000 = $2,100,000.
Step 2: year-one recapture. The $100,000 of Section 1245 recapture is ordinary income in year one.
Step 3: gross profit percentage. Gross profit excluding recapture: $2,100,000 - $100,000 = $2,000,000. Contract price: $3,000,000. GPP: 66.67%.
Step 4: gain by year.
| Year | Principal received | Installment gain | Character | Federal tax on the gain |
|---|---|---|---|---|
| 1 | $750,000 | $500,000, plus $100,000 recapture | $500,000 unrecaptured §1250 (25% max) + $100,000 ordinary | $145,270 |
| 2 to 11 | $225,000 each | $150,000 each | Long-term capital gain | $22,500 each |
| Total | $3,000,000 | $2,100,000 | $370,270 |
Because Reg. §1.453-12 takes the unrecaptured §1250 gain first, all $500,000 of it lands in year one with the down payment. The later payments carry only 15% capital gain for this couple.
Compare a cash sale. The same $2,100,000 gain in one year costs $434,763 of federal income tax, because most of the capital gain lands above the $613,700 top of the 15% band for joint filers and is taxed at 20%. The note saves about $64,500 of federal income tax in this simple example, in exchange for ten years of credit risk on the buyer. The note's interest adds ordinary income every year, which this table leaves out.
Change one fact and the answer moves. With a $1,000,000 mortgage paid off at closing from the buyer's funds, year one would carry $1,000,000 more in payments and far more gain. With heavy cost segregation, more of the gain would be year-one recapture. Test your own facts in the calculator.
Underwriting the buyer and the building
A tax saving means nothing if the note goes bad. Before you agree:
- Get the buyer's financial statements, tax returns and credit, and those of any guarantors.
- Look at the property's income. Will the rents support your payment and any senior loan with room to spare?
- Decide what happens if a major tenant leaves. Is there a reserve?
- Use an attorney to draft the note, deed of trust or mortgage, assignment of rents and guaranties. Record everything.
- Plan for default. Foreclosure takes time and money, and a repossession has its own tax rules under §1038. See what happens if the buyer defaults.
Bottom line
Seller financing commercial real estate can support a higher price and spread a large gain, but only part of it. Cost segregation recapture and any mortgage paid off at closing land in year one, and the unrecaptured §1250 layer (taxed at up to 25%) comes out of the first payments. What spreads is the long-term capital gain, which is often the largest layer on a long-held building. Underwrite the buyer like a bank, document the note like a bank, and run the numbers before you sign. For the book on timing gain against rental losses, get The Waterfall Strategy.
Questions to ask your CPA
- How much of my depreciation is Section 1245 (cost segregation) and how much is straight-line Section 1250?
- What is my gross profit percentage, and how much gain lands in year one with this down payment?
- Will any mortgage be paid off at closing, and how does that change year one?
- Will my installment notes this year exceed $5 million outstanding at year end, triggering §453A?
- What minimum interest rate avoids imputed interest for this note's term?
- Is my gain passive, and do I have suspended passive losses that can absorb it in the years it lands?
- What does my state tax on each year's installment gain, including if I move?
Run your own numbers. Compare a cash sale, seller financing and a structured installment sale side by side, free.
Educational only, not tax, legal or investment advice. Examples are illustrative. Have your CPA or tax attorney review your facts before you act. Hans Goldstein is a licensed insurance agent (CA Insurance License #4273294) and is not a CPA or attorney. He is paid a commission only if a structured installment sale is funded; seller financing pays him nothing. Disclosures.