Final answer:
Interest received on an installment sale is reported as income in the year it is received, separate from the principal payments, and is considered taxable income.
Step-by-step explanation:
Interest received on an installment sale is reported as income in the year it is received. When a sale is made under the installment method, the total gain is deferred and spread out over the period in which the installment payments are received. However, interest income must be reported separately in the year it is received and cannot be deferred. This interest is considered taxable income and is reported on IRS Form 1040 Schedule B if it is from a seller-financed mortgage, or it might be included on Schedule C or E if it relates to business or rental activities.
Here's an example for clarity: If a seller finances a property sale for a buyer and charges 5% interest on the balance due, the interest received each year from the buyer is reported on the seller's tax return as interest income for that year, separate from the installment sale income.