We are looking at taking back a significant seller note to defer our capital gains tax under an IRC Section 453 installment sale, but our CPA warned us about depreciation recapture. How does Section 453 treat our taxes upon sale, and what terms should we structure into the note to ensure the deferral actually benefits us?

Question

Tyler Smith · Accepted Answer

An installment sale under Internal Revenue Code Section 453 allows sellers to defer capital gains recognition until the year cash payments are actually received. This is a common and effective way to manage your tax brackets and spread the liability across multiple years. However, Section 453 has a major structural trap that catches unprepared owners: depreciation recapture.

Under federal tax law, all depreciation recapture under Section 1245 (such as machinery, equipment, and vehicles) and Section 1250 must be recognized and paid in the year of the sale, regardless of how much cash you actually collected at close. If you have heavily depreciated equipment on your balance sheet and sell via an asset purchase, you could face an immediate, ordinary income tax bill on that recapture without having received the cash from the buyer to cover it.

To ensure an installment sale benefits you, take three practical steps. First, calculate your exact recapture liability before signing the letter of intent. Demand a cash payment at closing that is at least large enough to cover all immediate federal, state, and recapture taxes triggered on day one.

Second, negotiate the purchase price allocation. Under an asset sale, allocate purchase price away from fast-depreciating personal property subject to Section 1245 recapture and toward capital assets or goodwill, which qualify for installment treatment.

Third, structure the note terms to reflect your role as a lender. Insist on a market-rate coupon that exceeds the IRS Applicable Federal Rate, set monthly or quarterly amortization schedules rather than a balloon maturity, and require personal guarantees or senior liens on the company stock or assets. You are taking credit risk; make sure the note yields real interest income and protects your principal.