How does Section 453 handle depreciation recapture on real estate sales, and can it be deferred?

Question

Tyler Smith · Accepted Answer

Section 453 generally allows for the deferral of capital gains on installment sales. However, a significant carve-out exists for depreciation recapture, particularly under IRC Section 1250 (for real estate) and Section 1245 (for personal property). Unlike other gains, *depreciation recapture income cannot be deferred under Section 453*. Instead, it must be recognized in the year of the sale, even if no cash payment has been received.

This immediate recognition of recapture income can create a cash flow challenge for sellers, as they owe tax on a portion of the gain without having received the corresponding proceeds. The IRS treats the recapture amount as ordinary income, which is taxed at higher rates than long-term capital gains. To calculate the recapture, you determine the portion of the gain attributable to depreciation previously taken. This amount is then recognized first, up to the total gain, before any remaining gain is treated as a Section 453 installment sale gain.

For example, if you sell a property for $1,000,000 with a basis of $600,000, and $100,000 of that gain is due to depreciation recapture, the $100,000 must be recognized immediately. Only the remaining $300,000 of the gain ($400,000 total gain - $100,000 recapture) would be eligible for installment sale treatment. Proper planning is crucial to anticipate and manage this immediate tax liability.