How does Section 453 handle depreciation recapture on the sale of real property?

Question

Tyler Smith · Accepted Answer

When selling depreciable real property using a Section 453 installment sale, the rules for depreciation recapture differ from ordinary gain. The IRS requires that any depreciation recapture, specifically Section 1250 unrecaptured depreciation, must be recognized in the year of the sale, regardless of when the installment payments are received. This means that even if you structure the sale to defer capital gains over several years, the portion of the gain attributable to depreciation recapture will be taxed immediately as ordinary income, not capital gain. This immediate recognition can significantly impact the cash flow from the sale in the initial year.

For example, if you sell a commercial property for $1,000,000 with a basis of $600,000, and $100,000 of the gain is due to depreciation taken, that $100,000 would be taxable in the year of sale. The remaining $300,000 of capital gain would then be deferred under the Section 453 installment method. Sellers need to be aware of this specific rule to avoid unexpected tax liabilities in the year of closing. Proper financial planning is crucial to ensure liquidity for this immediate tax obligation, even when using an installment sale to defer most of the capital gains.