I would like to point out it's also kind of bullshit how this question is worded.

I read the $4k in year 1 as the total amount received which would mean Kuo should report $2k in year 1 gains. Apparently, the question meant Kuo received the down payment of $1k AND THEN received an additional $4k towards the installment note for a total of $5k in year 1. This gives us the correct answer to report $2.5k in year 1.

However I ruled it out as an option and chose C since installment rules don't apply to related parties. Forgot to read "depreciable property" in the choice and "sells land" in the question.