We are structuring an exit using an installment sale under Section 453 to spread out our capital gains taxes over five years, but our assets include fully depreciated equipment and unbilled receivables. How does depreciation recapture impact our year-one tax bill?

Question

Tyler Smith · Accepted Answer

An installment sale under Internal Revenue Code Section 453 allows sellers to defer capital gains by recognizing taxable income proportionally as cash payments are received. However, many business owners get blindsided because Section 453 does not defer all taxes equally. The biggest trap in an asset purchase is depreciation recapture under Section 1245.

Under federal tax law, all depreciation recapture on personal property must be recognized as ordinary income entirely in the year of sale, regardless of how much cash you actually receive at closing. If your company holds two million dollars in fully depreciated machinery, software, or equipment, and the purchase price allocation assigns two million dollars to those assets, you owe ordinary income tax on that entire two million dollars on your next tax filing. If your cash at closing was only twenty percent of the deal, your immediate tax bill can exceed the cash you put in your bank account.

Furthermore, Section 453 explicitly disallows installment sale treatment for inventory and accounts receivable. If you sell unbilled receivables or finished goods, that revenue is recognized immediately in year one at ordinary income rates.

To manage this risk, take two direct actions:
- Negotiate the asset purchase price allocation aggressively during the letter of intent stage. Push purchase value toward goodwill and intangible assets rather than depreciable equipment or inventory, because goodwill qualifies for true installment treatment under Section 453 at long-term capital gains rates.
- Structure your closing cash distribution to be large enough to pay all year-one depreciation recapture and ordinary income liabilities with cash in hand, preserving the installment note strictly for capital gain deferral.