We are negotiating an asset sale with a substantial installment note under Section 453, but our CPA warned us that depreciation recapture on our equipment cannot be deferred. How does Section 453 handle depreciation recapture, and how should we structure asset allocation to prevent an unexpected year-one tax bill?

Question

Tyler Smith · Accepted Answer

Section 453 allows taxpayers to defer capital gains tax across multi-year installment notes, but it contains a critical trap for asset sales: depreciation recapture under Section 1245 and Section 1250 cannot be deferred. All accumulated depreciation on equipment, machinery, and vehicles is recognized and taxed as ordinary income in the year of sale, regardless of how little cash you collect at closing.

If you sell your business assets for ten million dollars with eight million dollars funded by a seller note and only two million dollars in cash at close, an enormous depreciation recapture burden could swallow your entire upfront cash receipt. You would face a substantial ordinary income tax bill on phantom proceeds you have not yet collected.

To solve this, address purchase price allocation early in LOI negotiations using IRS Form 8594 asset classes. Class VII assets (goodwill and going concern value) qualify fully for Section 453 installment reporting and generate long-term capital gains. Work with your transaction team to defend a higher valuation allocation to goodwill, customer relationships, and proprietary workflows, while keeping tangible equipment allocations aligned with true fair market scrap or depreciated values.

If significant recapture is unavoidable due to heavy historical capital expenditures, your transaction structure must mandate an upfront cash down payment that fully covers the year-one tax liability for all shareholders. Never accept an installment note schedule that defers your cash collection past the date your ordinary income tax obligations come due.