We want to structure twenty percent of our transaction as an installment sale under Internal Revenue Code Section 453 to spread out our capital gains tax, but our CPA warned us about depreciation recapture. How does Section 453 treat recapture, and how should we negotiate purchase price allocation to manage this tax hit?

Question

Tyler Smith · Accepted Answer

Section 453 allows sellers to defer capital gains tax liability by recognizing gain proportionally as installment payments are collected over future tax years. However, Section 453(i) contains a severe trap for business owners: all depreciation recapture under Section 1245 and Section 1250 must be fully recognized as ordinary income in the year of sale, regardless of whether you received any cash.

If you sell assets where equipment, vehicles, or technology have been heavily depreciated via bonus depreciation, you could face an immediate, catastrophic ordinary income tax bill in year one while holding an illiquid promissory note that pays out over five years.

To manage this exposure, negotiate the purchase price allocation under Section 1060 during the Letter of Intent stage, not after the definitive purchase agreement is drafted. Direct as much purchase price as legally justifiable into Class VII assets like goodwill, customer relationships, and going-concern value. These assets are capital gain assets that qualify fully for installment reporting under Section 453.

Ensure that the cash-at-close component of your deal covers your entire year-one tax liability, including all depreciation recapture, state taxes, and transaction advisory fees. If the buyer insists on a heavy equipment allocation that triggers heavy recapture, negotiate a higher cash consideration at closing to fund the tax bill.