How is depreciation recapture taxed when I sell my business?
Recapture is taxed as ordinary income, up to the amount of depreciation you deducted on the asset. Any gain above the asset's original cost is capital gain. Any amount between its depreciated tax basis and its original cost is recapture.
Here is the mechanism. Every year you deduct depreciation on a truck, a machine or a build-out, the asset's tax basis drops. When you sell it for more than that reduced basis, the IRS treats the difference as a clawback of deductions you already used against ordinary income. It taxes that clawback at ordinary rates.
Buildings follow a related rule. Gain on real estate that traces back to depreciation is taxed under its own maximum rate, separate from both ordinary income and standard capital gains. Your CPA will give you the exact rate for your bracket.
This matters most for owners who took accelerated or bonus depreciation. Those deductions pulled the basis close to zero, so almost the whole allocated price becomes recapture. Ask your CPA for a tax basis schedule by asset before you accept a letter of intent, so you know which assets carry recapture and which do not.
Why does the purchase price allocation change my recapture bill?
In an asset sale, you and the buyer divide the price across asset categories, and each category is taxed differently. Equipment and vehicles produce recapture. Goodwill produces capital gain. Buyer and seller each report the split to the IRS, and when the purchase agreement sets the allocation, both sides are expected to report the same numbers.
The two sides want opposite things. A buyer wants more price on equipment because it can be written off faster. You want more price on goodwill because it is taxed at the lower capital gains rate. A higher allocation to equipment can cost you real after-tax proceeds even when the headline price does not move.
Read how goodwill is taxed to see the other side of this split. The structure itself also matters. In a stock sale, the seller generally sells shares and the asset-level recapture problem mostly disappears for the seller, though the buyer gives up the stepped-up basis and often prices that in. The asset sale versus stock sale comparison covers that trade.
Treat the allocation as a term to negotiate at LOI, not a form to fill out at closing. Once the buyer's lender and attorney have built the closing documents around a number, moving it costs you negotiating position and time.
Does recapture affect SDE and my asking price?
Recapture does not change your SDE, but it changes what you keep from a price built on SDE. SDE adds depreciation back to net profit because depreciation is a non-cash expense. A buyer pays a multiple of that earnings figure, and the allocation then decides the tax you owe on the proceeds. See how SDE is calculated for the add-back mechanics.
An equipment-heavy company can look attractive on SDE and still hand you a large ordinary income bill at closing. A service company with little equipment has little recapture. Two sellers with the same price can net very different amounts after tax.
One more mechanic catches owners off guard. If part of your price comes as a seller note, recapture income is generally recognized in the year of sale, even though the cash arrives later. If that note sits on full standby for the life of an SBA loan, you can owe tax on income you have not received. Model that cash gap with your CPA before you agree to the note.
What can I do about depreciation recapture before I sell?
You cannot eliminate recapture in an asset sale, but you can measure it, support the allocation and compare offers on a net basis. Three steps help.
- Build the basis schedule. List each depreciated asset with its cost, accumulated depreciation and current tax basis.
- Support the equipment value. A buyer's lender will test it, and an appraisal of equipment and vehicles gives you evidence for a split you can defend.
- Compare offers after tax. A higher price with heavy equipment allocation can net you less than a lower price weighted toward goodwill.
Bring your CPA in before marketing begins, not after the LOI. Our owner's guide to selling a business shows where tax planning fits in the preparation window, which runs 4 to 8 weeks on Munera's timeline.
Frequently asked questions
Do I owe depreciation recapture if I sell my business for a loss?+
No recapture arises on an asset sold for less than its depreciated tax basis, because there is no gain to claw back. The loss may be deductible instead. Your CPA will check this asset by asset, since one asset can produce recapture while another produces a loss.
Is depreciation recapture owed on a stock sale?+
A seller of shares generally reports capital gain on the stock and does not trigger asset-level recapture. The buyer inherits the old tax basis and loses the step-up, so many buyers ask for a lower price or push for an asset deal. Some structures, such as an election that treats a stock sale as an asset sale for tax, bring recapture back.
Who decides the purchase price allocation?+
You and the buyer negotiate it, usually at the letter of intent stage, and both report the same split to the IRS. Each side has a tax reason to push the numbers its own way. An equipment appraisal gives you a neutral figure to anchor the discussion.
Does depreciation recapture apply to an LLC or S corporation?+
Yes. In a pass-through entity, the recapture income flows through to the owners and is taxed on their personal returns. A C corporation pays tax on the gain at the entity level, and the owner is taxed again on distributions, so the structure of your entity changes the math.