Do You Recapture Depreciation on an Installment Sale?

In a previous blog, we discussed the benefits of selling real estate assets through installment sales. Offering an installment sale agreement could widen the buyer pool. Additionally, this method can help decrease capital gains taxes.

While an installment sale can reduce a seller’s tax burden, it doesn’t eliminate it; the process simply defers it. Furthermore, an installment sale doesn’t mean you can eliminate or defer depreciation recapture taxes.

Defining the Installment Sale

An installment sale occurs when you and a buyer of your real estate agree that you’ll receive the amount owed over a period of time, as opposed to receiving that payment in one lump sum. The IRS indicates that a bonafide installment sale means you receive at least one payment after the tax year in which the sale occurs. For instance, let’s say you sell a duplex for $500,000 and agree to receive payments from the buyer over a 10-year period. As long as the buyer pays you the $50,000 the year after the deal closes, this is an installment sale from the IRS’ point of view.

Through such an arrangement, you only report the gain you receive by filing Form 6252—Installment Sale Income. Furthermore, you would only pay capital gains taxes on what you received. In the above case, the tax would be on the $50,000 rather than the total $500,000.

A Depreciation Recapture Discussion

The situation is different when discussing depreciation recapture taxes. While you owned that property, you could likely deduct depreciation expenses against any income you earned. Depreciation refers to the allocation of real estate’s cost over that asset’s “useful life.” This totals 27.5 years for residential properties and 39 years for commercial assets. 

But when you sell that property, the IRS wants part of its money back. This happens through depreciation recapture, up to 25% of the depreciation allowance taken over your investment’s holding period.

Let’s say that in the above example, you purchased the above property for $400,000 and owned it for ten years. The property’s annual depreciation would be approximately $14,545.45 ($400,000/27.5 years).

• Your adjusted cost basis would be $400,000 – ($14,545.45 x 10) = $254,545.50
• So the realized gain on your sale would be $500,000 - $254,545.50 = $245,454.50
• The depreciation recapture tax would be 25% x $245,454.50 = $61,363.62

The challenge here is that depreciation taxes aren’t deferred or “spread out, " unlike capital gains taxes.” According to the IRS, you must report “any portion of the gain from the sale of depreciable assets that’s ordinary income under the depreciation recapture rules in the year of the sale.” In English, this means you must report the entire depreciation recapture amount – and pay that tax – to the IRS in the same year the sale takes place. 

In the above example, the depreciation recapture tax generated during the year you sold the duplex will exceed the $50,000 payment agreed to with the installment sale.

Understanding What’s Owed

The installment sale can be a tool to help defer certain taxes from the sale of an asset. But 100% of the depreciation recapture tax must be paid at once. Before determining if using an installment sale is beneficial, talk to a tax professional who can provide advice.