The rule: recapture in year one
IRC Section 453(i) requires that depreciation recapture — both unrecaptured Section 1250 gain and Section 1245 gain — be recognized in the year of sale, regardless of when the buyer's installment payments arrive. You cannot spread the recapture portion over the life of the note. Only the capital gain above the recapture amount qualifies for installment sale deferral under Section 453.
This is the critical limitation of installment sales for rental investors: if your accumulated depreciation is large relative to your total gain, little or nothing is deferrable, and you face a significant tax bill in year one even though you received only a down payment.
How the math works
Example: adjusted basis $100,000, depreciation claimed $200,000, original cost $300,000. Sell at $500,000 on a 5-year installment note, receiving $100,000 down and $80,000/year for five years.
Total gain: $500,000 − ($300,000 − $200,000) = $400,000. Recapture amount: $200,000 (taxed at up to 25% in year one). Capital gain above recapture: $200,000 (deferrable via installment). Gross profit ratio for installment: $200,000 ÷ $500,000 = 40%. Each $80,000 annual payment includes $32,000 of deferred capital gain (40% × $80,000) reported over the 5-year period. But the $200,000 recapture is all reported in year one regardless.
When installment sales still make sense despite recapture
Even if you must report all recapture in year one, deferring the capital gain portion can still be valuable — especially if it keeps your total income below the 20% capital gains threshold or below the NIIT threshold in subsequent years. The key is to have enough liquidity from the down payment to cover the year-one recapture tax bill. Model the cash flow carefully: you need to pay the IRS more tax than you received in cash in year one if the down payment doesn't cover the recapture tax.
Frequently asked questions
Can I defer depreciation recapture with an installment sale?
No. Under IRC 453(i), both Section 1245 and unrecaptured Section 1250 recapture are fully recognized in the year of sale. Only capital gain above the recapture amount can be spread over the installment period.
What if the down payment is less than my recapture tax?
You will owe more in taxes in year one than you received in cash. You need to have other funds available to pay the tax, or negotiate a larger down payment to cover the estimated recapture liability.
Is a 1031 exchange better than an installment sale for deferring recapture?
Yes. A 1031 exchange defers all gain including all recapture. An installment sale defers only the capital gain above recapture, while recapture is taxable immediately.
Sources
- IRS Topic No. 409 — Capital Gains and Losses
- IRS Publication 544 — Sales and Other Dispositions of Assets
- IRS Publication 946 — How to Depreciate Property
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.