Understanding Why Recapture Tax is Paid in Full at Closing — Even with a Seller Financing Note
When selling a business or investment property, many owners are surprised to learn that recapture tax on depreciation is due in full at closing, even if part of the deal involves seller financing. This detail can have a major impact on your cash flow and tax liability — and ignoring it can lead to expensive surprises come tax season.
What Is Recapture Tax?
Over the course of owning a depreciable asset — such as real estate, equipment, or fixtures — you likely took depreciation deductions each year to reduce your taxable income. While depreciation provides valuable tax savings during ownership, the IRS eventually wants that money back when you sell.
This is where depreciation recapture comes in. When the asset is sold, the IRS “recaptures” the total depreciation taken, taxing it at a higher rate — up to 25% for real estate. It applies to the portion of your gain attributable to depreciation, not the total capital gain.
The Seller Financing Misconception
Many sellers assume that if they finance part of the sale through a seller note (installment sale), they can spread their tax liability — including recapture tax — over time as they receive payments. While that may be true for capital gains, it’s not true for depreciation recapture.
The IRS treats depreciation recapture differently. Under Section 453 of the Internal Revenue Code, recapture income is not eligible for installment sale treatment. That means it must be reported — and taxes paid — in the year of the sale, regardless of how much of the sales price was actually collected at closing.
An Example
Let’s say you sell a commercial property for $1 million. Your adjusted cost basis, after years of depreciation, is $600,000 — including $250,000 in depreciation taken. The gain is $400,000, of which $250,000 is subject to recapture tax, and the remaining $150,000 is a capital gain.
You agree to seller-finance 50% of the deal, receiving only $500,000 at closing. Even though you only pocket half the sale proceeds, you’ll owe taxes on the full $250,000 of depreciation recapture in the year of sale, which could be up to $62,500 in tax (25%).
You’ll pay this recapture tax out-of-pocket, potentially even before collecting all the payments due from the buyer over time. This can create serious cash flow strain, especially if you haven’t planned for it.
Planning Ahead
For sellers considering seller financing, it’s critical to work with your accountant and broker to estimate tax exposure upfront. In many cases, sellers increase the down payment requirement or adjust the terms of the seller note to help cover their immediate tax obligations.
Alternatively, if the asset qualifies, consider using a 1031 exchange (for real estate) to defer the recapture tax entirely — but remember, this strategy only applies if you reinvest in like-kind property and follow strict IRS timelines.
Final Thoughts
Recapture tax is often the most overlooked and misunderstood tax consequence of selling a business or investment property. The fact that it must be paid in full at closing, even if the buyer is paying in installments, can drastically affect your net proceeds and tax liability.
Don’t let depreciation catch you off guard — proper tax planning is essential to maximizing the return on your sale. Would you like this post turned into a branded flyer or web article?
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1031 Exchange and Seller Financing: What Portion Can Be Reinvested?
A 1031 exchange is one of the most powerful tools available to real estate investors looking to defer capital gains taxes and depreciation recapture when selling an investment property. However, when a deal involves seller financing (a seller note), many sellers and even professionals are confused about how that affects the exchange and what portion of the proceeds can be reinvested.
The short answer: Only the cash and equity actually received at the time of closing — not the note — can be used to fund a 1031 exchange.
Let’s break this down.
What Is a Seller Note?
A seller note (or seller financing) is when the seller agrees to receive a portion of the sale price over time, acting as the lender. The buyer gives a promissory note and pays back the principal with interest on an agreed schedule. While this can be an effective tool to facilitate deals, it introduces complications for tax planning — especially in a 1031 exchange.
What Is a 1031 Exchange?
A Section 1031 exchange allows an investor to sell a property and reinvest the proceeds into another “like-kind” investment property, deferring both capital gains and depreciation recapture taxes. To qualify, the seller must follow strict timelines and reinvest all net proceeds and debt relief into the replacement property.
How a Seller Note Affects the 1031
In a 1031 exchange, the IRS allows only the proceeds received and held by a qualified intermediary (QI) to be reinvested. If part of the sale proceeds is tied up in a seller-financed note, that portion cannot be used to buy the replacement property, and is not eligible for deferral under Section 1031.
This means the amount of the seller note is treated as “boot” — a portion of the sale that does not qualify for deferral — and is taxable in the year of the sale or as payments are received, depending on how it’s structured.
Example Scenario
Let’s say you sell a commercial building for $1 million:
$700,000 is paid at closing and transferred to a qualified intermediary
$300,000 is carried by the seller as a note payable over 5 years
Only the $700,000 can be used in the 1031 exchange. The $300,000 seller note is considered boot. Even though you haven’t received that money yet, the IRS treats it differently than cash because it’s not reinvested into the replacement property.
You may be able to structure the note to qualify for installment sale treatment, allowing you to spread the taxes on the boot over time — but this applies only to capital gains, not to depreciation recapture.
Best Practices
If you’re planning a 1031 exchange and want to offer seller financing, consider these tips:
Limit the size of the seller note to reduce taxable boot
Sell the note to a third party and reinvest those proceeds in the exchange (advanced strategy)
Work with an experienced QI and tax advisor to structure the deal properly
Final Thought
A 1031 exchange and seller financing can coexist, but only the cash proceeds transferred to the qualified intermediary can be reinvested tax-deferred. If part of your sale includes a seller note, be prepared for potential tax liability on that portion. Careful planning upfront ensures you maximize the benefits and avoid surprises.
