We plan to accept a 40 percent seller note paid over five years to defer taxes under Section 453, but our CPA warned that depreciation recapture will trigger immediate tax liabilities. How does Section 1245 depreciation recapture affect our year-one tax liability on an installment sale, and how much cash do we need at closing to cover it?

Question

Tyler Smith · Accepted Answer

Many business owners mistakenly believe that an installment sale under Section 453 defers all taxes proportionally as promissory note payments are received. That is not how the internal revenue code works when your company holds depreciable equipment, machinery, or capitalized assets.

Under Section 453(i), all depreciation recapture income under Section 1245 or Section 1250 must be recognized as ordinary income in the exact year of the sale, regardless of how much cash you actually receive at closing.

For example, if you sell your assets for 10 million dollars with 4 million dollars in cash and a 6 million dollar seller note, but you have 2.5 million dollars in accumulated depreciation subject to Section 1245 recapture, that entire 2.5 million dollars is taxed immediately at ordinary income rates in year one. You cannot spread that specific liability over the life of the installment note.

If you take back a high percentage of seller financing without calculating this recapture, you can easily face a phantom tax crunch where your year-one federal and state tax bills consume nearly all your net cash proceeds at close.

To avoid this trap, run a complete pre-LOI asset allocation analysis. Determine the exact breakout among asset classes, identifying the exact dollar amount of accumulated depreciation.

Structure your cash-at-close floor so that it covers:

- One hundred percent of the tax owed on Section 1245 depreciation recapture at your highest marginal ordinary income rate.
- The capital gains tax owed on the cash received in year one.
- All transaction expenses, legal fees, and advisory commissions.

Never let seller financing push your cash at closing below the threshold needed to settle your immediate tax obligations in full.