Depreciation Recapture in Seller Financed Transaction

[Robert McEachern]

Hello All:

I am trying to purchase a 4-plex using seller financing and the Seller's accountant is telling the Seller that they need to receive enough of a down payment to cover the depreciation recapture which is taxable in the year of the sale.  Is this true?  I have never heard of this.  Is there a way for the seller to somehow defer that tax?

For reference, the terms of the transaction are:  $0 down and monthly interest only payments at 6% with the balance due in 7 years.

Thank you in advance for your help.

Rob

[Brandon Hall]

@Kim B.@Roy N.@Bill Gulley@Brian Gibbons

Unfortunately, Nathaniel is incorrect in stating that "normal" straight line depreciation is not subject to recapture in the year of the sale. He further cites that "normal" depreciation does not stem from Section 1245 or Section 1250 property. Let me try to explain and correct the thinking:

Section 1245 property can generally be thought of as personal property. Section 1250 property is defined as "depreciable real property that is not Section 1245 property." A rental property therefore falls under the Section 1250 definition since it is depreciable real property, but not considered personal property.

Section 1250 property is subject to depreciation recapture at a rate of 25%. This recapture is ALWAYS due in the year of the sale, regardless of how the sale is structured. Realized gain in excess of depreciation recapture is treated as capital gain. This excess gain will be subject to installment sale rules, meaning it can be spread out over the life of the loan.

Per IRS publication 537 - Installment Sales: 

"Depreciation Recapture Income

If you sell property for which you claimed or could have claimed a depreciation deduction, you must report any depreciation recapture income in the year of sale, whether or not an installment payment was received that year. Figure your depreciation recapture income (including the section 179 deduction and the section 179A deduction recapture) in Part III of Form 4797. Report the recapture income in Part II of Form 4797 as ordinary income in the year of sale. The recapture income is also included in Part I of Form 6252. However, the gain equal to the recapture income is reported in full in the year of the sale. Only the gain greater than the recapture income is reported on the installment method. For more information on depreciation recapture, see chapter 3 in Publication 544."

https://www.irs.gov/publications/p537/ar02.html#en...

Per IRS pub 544, Chapter 3:

"Installment Sales

If you report the sale of property under the installment method, any depreciation recapture under section 1245 or 1250 is taxable as ordinary income in the year of sale. This applies even if no payments are received in that year. If the gain is more than the depreciation recapture income, report the rest of the gain using the rules of the installment method. For this purpose, include the recapture income in your installment sale basis to determine your gross profit on the installment sale.

If you dispose of more than one asset in a single transaction, you must figure the gain on each asset separately so that it may be properly reported. To do this, allocate the selling price and the payments you receive in the year of sale to each asset. Report any depreciation recapture income in the year of sale before using the installment method for any remaining gain."

https://www.irs.gov/publications/p544/ch03.html#en...

So this is why it's always a good idea to get an opinion (or second opinion) from a qualified professional. Everyone makes mistakes.