How does Section 453 interact with the recognition of ordinary income from depreciation recapture?

Question

Tyler Smith · Accepted Answer

Section 453 provides for the deferral of capital gains; however, it has specific rules regarding depreciation recapture that prevent its deferral. When property subject to depreciation is sold in an installment sale, any depreciation recapture must be recognized as ordinary income in the year of sale, regardless of whether any cash payments are received in that year. This is a critical point for sellers to understand, as it can result in a tax liability even if no cash proceeds have yet been collected.

For instance, if a business sells equipment for $500,000 using an installment note, and the equipment has $100,000 in depreciation recapture (IRC Section 1245 property), the seller must recognize that $100,000 as ordinary income in the year the sale occurs. The remaining gain, after accounting for the depreciation recapture, can then be deferred and recognized proportionally as installment payments are received. This means that even if the first payment on the installment note is not due until the following year, the seller will still owe tax on the $100,000 of ordinary income from recapture in the sale year.

The same principle applies to IRC Section 1250 recapture for real property, though Section 1250 recapture is generally less prevalent after changes in tax laws, often resulting in unrecaptured Section 1250 gain taxed at a maximum 25% rate rather than ordinary income rates. Understanding this acceleration of ordinary income is vital for cash flow planning, as it can create an immediate tax bill without corresponding cash receipts from the sale.