Recognition on Installment Notes

Course: Estate Planning
Lesson 12: Valuation and Freeze Techniques to Reduce Estate Tax Liability
Student Question:
I’m not sure how gains are spread out over the course of the note if these are typically
structured “as interest only with a balloon payment at the end”. Here’s the language from the lesson:
Instead of an outright sale, an alternative is an installment sale, which has a set contract price that is paid through a series of installment payments over a specified period of time. Typically, they are structured as interest-only payments with a balloon payment at the end of the term.
This method freezes the value of the assets sold, with the unpaid balance reflected as a note in the seller’s estate. It is an especially useful technique if the property being sold is expected to appreciate significantly in future years.
Instructor Response:
That’s an astute observation.
In a traditional installment note the seller receives principal monthly. The seller recognizes capital gain under this formula: Gross Profit Percentage x Principal Received. An interest only note defers the recognition of realized gain even farther than a traditional installment note. When the principal is paid at the end of the note term, the capital gain is recognized in the year principal is received.