We want to use a Section 453 installment sale to spread our tax liability over several years, but we are worried about how depreciation recapture and the IRS interest charge on deferred tax might erode our net proceeds. How do we structure the asset allocation to minimize these tax penalties?

Question

Tyler Smith · Accepted Answer

Spreading your capital gains over several years using a Section 453 installment sale is an excellent strategy, but you must be careful not to let depreciation recapture and IRS interest charges wipe out your tax savings. When you structure an installment sale, the IRS does not allow you to defer taxes on depreciation recapture. Any accumulated depreciation on machinery, equipment, or software under Section 1245 must be recognized as ordinary income in the year of the sale, regardless of when you actually receive the cash payments. To minimize this immediate tax hit, you must negotiate a favorable asset allocation in your purchase agreement. Work with your advisory team to allocate a higher portion of the purchase price to capital assets that are eligible for capital gains treatment, such as goodwill and customer lists, rather than fast depreciating equipment or short term personal property. Furthermore, you must watch out for the Section 453A interest charge. If your total outstanding installment obligations exceed five million dollars at the end of the tax year, the IRS imposes an annual interest charge on the deferred tax liability. To manage this threshold, you can structure the payout schedule across multiple tax years or split the transaction among different corporate entities or shareholders, provided you stay fully compliant with IRS regulations. By carefully balancing your asset allocation to limit depreciation recapture and monitoring the five million dollar threshold, you can protect your net proceeds and ensure that your deferred payments actually work to your financial advantage rather than creating an unexpected tax burden.