We are structuring an asset sale using a Section 453 installment note to spread our taxable income across five years, but our CPA says depreciation recapture is due immediately in year one. How do we structure the down payment and cash at close to prevent a phantom tax bill?

Question

Tyler Smith · Accepted Answer

Section 453(i) of the Internal Revenue Code explicitly excludes depreciation recapture under Sections 1245 and 1250 from installment sale deferral. Any past depreciation you claimed on machinery, equipment, or accelerated improvements is taxed as ordinary income in the tax year of the sale, regardless of whether you received ten percent or ninety percent of the cash proceeds. If you structure a large installment note without calculating this liability upfront, you will owe substantial cash to the IRS without the closing liquidity to pay it.

To prevent a cash deficit at closing, apply these operational and structural rules:
- Calculate the recapture baseline before signing the LOI. Have your tax CPA run a detailed asset-class breakdown to identify your Section 1245 tangible personal property and Section 1250 real property recapture amounts.
- Mandate a minimum cash at close threshold. Set the cash down payment to cover the entire federal and state tax burden generated by immediate recapture, plus capital gains due on the cash received, plus your transaction advisory fees.
- Negotiate the purchase price allocation under Form 8594. Work with the buyer to allocate more value toward goodwill or customer lists (capital gains assets) and less toward fully depreciated equipment, provided the allocation withstands IRS scrutiny.
- Build a recapture shortfall clause into the note. If the buyer insists on a smaller cash down payment, mandate that the first installment payment occurs prior to your tax filing deadline, or require an initial principal drawdown timed specifically to cover estimated tax payments.

Treat tax structuring as a hard operational constraint, not an afterthought. Solve the recapture liability inside your deal model before exclusivity locks your negotiation leverage.