How does Section 453 impact the sale of a rental property with prior depreciation recapture?

Question

Tyler Smith · Accepted Answer

When a rental property is sold in an installment sale, any prior depreciation taken must be considered, particularly concerning depreciation recapture under Section 1250 (for real property). Unlike other types of gain, Section 1250 depreciation recapture cannot be deferred under the installment method. Instead, all unrecaptured Section 1250 gain must be recognized in the year of the sale, regardless of whether any cash payments are received in that year.

This means that even if a seller receives only a small down payment, or even no down payment in the year of sale (but will receive payments in future years), they are still required to pay tax on the full amount of the depreciation recapture in the year the property is sold. This can create a significant tax burden and a cash flow mismatch for sellers, as they might have a large tax liability without corresponding cash receipts from the sale. The remaining gain, after accounting for the depreciation recapture, can then be deferred and recognized under the Section 453 installment method as payments are received. Sellers of rental properties need to carefully analyze their depreciation recapture exposure and plan their liquidity accordingly to cover the tax liability arising from it in the year of sale.