Installment Sale Depreciation Recapture: Why Year One Gets Taxed
On an installment sale, depreciation recapture is split in two. Recapture on the fast-depreciated parts of a property (section 1245 property, including cost-segregation components) is taxed in full in the year of sale, even if you receive almost no cash that year (§453(i)). Ordinary straight-line depreciation on the building itself becomes "unrecaptured section 1250 gain," which is spread over the payments like the rest of the gain, but comes out of the earliest payments first and is taxed at up to 25%.
That split is the single most common surprise in seller-financed and structured sales. A seller expects the note to spread the tax, then finds a large year-one bill on money that has not arrived. This page explains the rule, shows the numbers, and lists the planning moves that actually help.
The rule: §453(i) recapture is taxed in the year of sale, with or without cash
Section 453 lets you report gain as you are paid. Section 453(i) carves out one piece. In the words of the statute, "any recapture income shall be recognized in the year of the disposition, and ... any gain in excess of the recapture income shall be taken into account under the installment method" (§453(i)(1)).
"Recapture income" is defined narrowly: the amount that would be ordinary income under §1245 or §1250 (or the part of §751 that relates to them, for partnership interests) if every payment were received in the year of sale (§453(i)(2)). Three consequences follow:
- It does not matter how little cash you get at closing. Take 5% down or 50% down; the recapture is the same.
- The recapture is added to your basis before the gross profit percentage is computed, so it is not taxed a second time when payments come in. IRS Publication 537 builds this into its basis worksheet.
- You report it on Form 4797 in the year of sale and carry it to Form 6252. See our walkthrough of the Form 6252 instructions.
Section 1245 vs unrecaptured §1250 vs capital gain: what is deferred and what is not
A rental building sale usually has up to three federal layers of gain, plus the 3.8% net investment income tax and state tax on top.
| Layer | Where it comes from | Federal rate | On an installment sale |
|---|---|---|---|
| §1245 recapture | Depreciation on personal property, including cost-segregated 5 and 7-year parts (carpet, appliances, cabinets, some fixtures) | Ordinary rates, up to 37% | Year of sale, in full (§453(i)) |
| §1250 "additional depreciation" | Depreciation faster than straight-line on real property, such as bonus or accelerated depreciation on 15-year land improvements (paving, landscaping) | Ordinary rates | Year of sale, in full (§453(i)). A post-1986 building on straight-line generally has none |
| Unrecaptured §1250 gain | Ordinary straight-line depreciation on the building | Your ordinary rate, capped at 25% (§1(h)(1)(E)) | Deferred with the payments, but recognized first (Reg. §1.453-12) |
| Long-term capital gain | Appreciation above your original cost | 0%, 15% or 20% | Deferred with the payments |
Three precision points that trip up even experienced preparers:
- Unrecaptured §1250 gain is not recapture income. Treasury's regulation says it "is reported on the installment method if that method otherwise applies" and "is taken into account before the adjusted net capital gain" (Reg. §1.453-12(a)). So it is deferred, not accelerated. It is simply front-loaded.
- 25% is a ceiling, not a flat rate. In a year when your ordinary bracket is below 25%, this layer is taxed at the lower bracket rate. See unrecaptured Section 1250 gain for how the cap works at different incomes.
- §1245 recapture is limited to the gain on those assets. Under §1245(a)(1) the recapture is the lesser of the depreciation taken or the gain attributable to the property. The part of the price allocated to worn carpet and ten-year-old appliances matters, and it should be supportable.
For 2026, a married couple filing jointly pays 0% on long-term gain up to $98,900 of taxable income and 15% up to $613,700, then 20% (Rev. Proc. 2025-32, §3.03). The 3.8% net investment income tax applies to modified AGI above $250,000 for joint filers.
Why cost segregation and bonus depreciation make year one worse
Cost segregation splits a building into short-life parts that depreciate much faster. For property acquired after January 19, 2025, 100% bonus depreciation is back for those parts (§168(k)(1), as amended by P.L. 119-21). The deduction on the way in is large. The bill on the way out lands in one year.
Every dollar of depreciation taken on a cost-segregated component is a potential dollar of year-one recapture income: §1245 recapture on the personal-property parts, and §1250 "additional depreciation" (anything beyond straight-line) on 15-year land improvements. Had the same dollar been taken as straight-line building depreciation, it would have been unrecaptured §1250 gain: spread with the note and capped at 25%. So a large study converts deferrable, capped gain into year-one ordinary income. For equipment, Section 179 and the full recapture rules, see Section 1245 recapture.
This does not make cost segregation a mistake. The deduction usually came years earlier, and money now beats money later. It does mean it pays to pull the depreciation schedule and any cost segregation study before the note terms are set. Our companion piece on cost segregation before selling covers the timing questions, and depreciation recapture in a 1031 exchange covers the §1245(b)(4) trap that can create recapture even with no boot. For the rules outside an installment sale, see the full guide to depreciation recapture.
Worked example: $2M rental with cost seg, 10-year note, year-one tax spike
Simple example. A couple bought a rental for $1,200,000. They took $350,000 of depreciation: $200,000 on cost-segregated 5 and 7-year parts (with bonus) and $150,000 of straight-line on the building. Adjusted basis: $850,000. They sell for $2,000,000 to an unrelated buyer, ignoring selling costs, with $200,000 down and a $1,800,000 seller-financed note paid $180,000 a year for ten years plus interest. Assume the price allocated to the cost-segregated parts is at least $200,000, so all $200,000 is recaptured.
Step 1: split the gain.
| Item | Amount |
|---|---|
| Selling price | $2,000,000 |
| Adjusted basis | $850,000 |
| Total gain | $1,150,000 |
| §1245 recapture (year of sale, §453(i)) | $200,000 |
| Installment gain (gross profit) | $950,000 |
| Of which unrecaptured §1250 gain | $150,000 |
| Of which long-term capital gain | $800,000 |
| Gross profit percentage ($950,000 / $2,000,000) | 47.5% |
The recapture is added to basis ($850,000 + $200,000 = $1,050,000), which is why gross profit is $950,000, not $1,150,000.
Step 2: recognize it year by year.
| Year | Principal received | Installment gain (47.5%) | §1245 recapture | 25% layer | Capital gain |
|---|---|---|---|---|---|
| 1 | $200,000 | $95,000 | $200,000 | $95,000 | $0 |
| 2 | $180,000 | $85,500 | $0 | $55,000 | $30,500 |
| 3 to 11 (each) | $180,000 | $85,500 | $0 | $0 | $85,500 |
| Total | $2,000,000 | $950,000 | $200,000 | $150,000 | $800,000 |
Step 3: the year-one bill. Using rough rates for a high-income couple (35% ordinary, 25% on the building layer, 3.8% net investment income tax on everything; interest and state tax ignored; simple example):
| Year-one federal tax | Amount |
|---|---|
| $200,000 recapture at 35% | $70,000 |
| $95,000 unrecaptured §1250 gain at 25% | $23,750 |
| 3.8% on $295,000 | $11,210 |
| Total year-one tax | $104,960 |
| Cash received in year one | $200,000 |
More than half of the down payment goes to federal tax, before any state tax. Same sale, no cost segregation (all $350,000 taken as straight-line building depreciation): no recapture income, a 57.5% gross profit percentage, and year-one gain of $115,000, all in the 25% layer. At the same rough rates that is about $33,120 of year-one federal tax. The cost segregation study roughly tripled the year-one bill on the same cash.
For comparison, a cash sale at those rough rates (recapture at 35%, $150,000 at 25%, $800,000 at 20%, plus 3.8% on $1,150,000) would owe about $311,200 in one year. The note still spreads most of the tax. It just cannot spread the recapture.
Run your own version in the installment sale calculator: it has separate inputs for §1245 and §1250 depreciation so the year-one split shows up automatically. The seller financing calculator adds note terms and interest.
Planning around it
You cannot defer §1245 recapture on an installment sale. You can plan for it.
1. Size the down payment to cover the year-one tax. In the example, $200,000 down barely covers year one after federal and state tax. A down payment large enough to pay the recapture tax, the first slice of the 25% layer, and state withholding keeps the seller from funding the IRS out of savings. In California, Form 593 withholding also applies to the cash at closing.
2. Meet the recapture with losses. For an owner who is not a qualifying real estate professional, all gain on selling a rental, including §1245 recapture, is passive activity income (Temp. Reg. §1.469-2T(c)(2)(i)(A)). Year one is often the best year to use suspended passive losses from other rentals or K-1s: they come off ordinary income first. See the installment sale guide and, for the full strategy, The Waterfall Strategy.
3. Support the allocation. Recapture on the short-life parts is capped at the gain on those parts (§1245(a)(1)). A documented allocation of the price, consistent between buyer and seller, keeps the recapture from being overstated.
4. Watch the §1231 lookback. If you had net §1231 losses in the prior five years, that much installment gain is ordinary (§1231(c)), and it eats the 25% layer first (Reg. §1.453-12(d), Example 3). Pull your last five Forms 4797.
5. Time the sale year. Recapture stacks on top of that year's wages and other income. A sale in a lower-income year (after retirement, between jobs) can drop recapture into a lower bracket.
6. Model the state separately. California does not allow bonus depreciation (R&TC §17250(a)(11)), so California basis, recapture and gain differ from federal, and California taxes all gain as ordinary income.
One thing that does not help: a structured installment sale instead of seller financing. Both use the same §453 rules, so §1245 recapture lands in year one either way. See how the gross profit percentage works for the rest of the math.
Bottom line
On an installment sale, ordinary recapture (§1245 on cost-segregated 5- and 7-year parts and other personal property, plus §1250(a) recapture of bonus or accelerated depreciation on 15-year land improvements) is taxed in the year of sale, all of it, regardless of how much cash you receive. Straight-line building depreciation is spread with the payments but comes out first at up to 25%. It helps to pull the depreciation schedule before the down payment is negotiated, so year one can cover the bill.
Questions to ask your CPA
- How much of my depreciation is ordinary recapture (§1245 on cost-seg 5- and 7-year parts and personal property, §1250(a) on bonus taken on 15-year land improvements) and how much is straight-line building depreciation?
- What price allocation to the short-life components can we support, and how does it change the recapture?
- What is my year-one federal and state tax at the down payment I am negotiating?
- Which suspended passive losses can meet the year-one recapture, and is my rental grouped with others?
- Do I have unrecaptured net §1231 losses from the last five years?
- How does California (or my state) treat the recapture and basis differently from federal?
Run your own numbers. Compare a cash sale, seller financing and a structured installment sale side by side, free.
Educational only, not tax, legal or investment advice. Examples are illustrative. Have your CPA or tax attorney review your facts before you act. Hans Goldstein is a licensed insurance agent (CA Insurance License #4273294) and is not a CPA or attorney. He is paid a commission only if a structured installment sale is funded; seller financing pays him nothing. Disclosures.