We are planning a Section 453 installment sale to defer our taxes, but our CPA warned us about depreciation recapture taxes being due immediately in year one regardless of cash received. How do we negotiate the asset allocation or deal terms to prevent a massive cash-flow crunch at closing?

Question

Tyler Smith · Accepted Answer

This is a classic trap that catches owners off guard. Under Section 453, while you can defer capital gains tax on the installment payments, any depreciation recapture under Section 1245 or 1250 is fully taxable in the year of the sale, even if you have not received a single dollar of the principal note yet. If your business is asset heavy or has accelerated depreciation on equipment, you could face a massive tax bill with no cash to pay it.

To solve this, you must focus on the purchase price allocation, which is filed on IRS Form 8594. Do not leave this as an afterthought for the lawyers to handle at closing. You need to negotiate a lower allocation to personal property subject to recapture, like machinery and equipment, and a higher allocation to goodwill or real property, which qualify for capital gains treatment and installment deferral.

If the buyer refuses because they want the tax benefits of step up depreciation, you must use this as a bargaining chip. Demand a larger down payment at closing to cover your immediate tax liability.

In your EOS planning sessions, make this allocation a priority Rock for your finance seat. Ensure they run multiple scenarios under IVS 105 to understand how different allocations affect your net cash proceeds. This keeps you from signing an LOI that triggers a tax bill you cannot afford.