Background and why it matters

When you sell a side business — whether you sell assets of a sole proprietorship, your partnership interest, or stock in a corporation — the tax outcome depends on how you allocate the sale price and on your adjusted basis in those assets. In my 15 years advising small-business clients I’ve seen basis mistakes create unexpected ordinary income tax (often from depreciation recapture) or misstated capital gains. The IRS expects accurate reporting; common guidance is summarized in IRS Publication 544 and the IRS resources on reporting capital gains and losses (see sources).

Key terms (quick)

  • Amount realized: cash plus liabilities assumed by buyer, plus the fair market value of other property received, minus selling expenses. Selling expenses reduce the amount realized. (IRS guidance)
  • Adjusted basis: original cost basis increased by capital additions (legal fees for acquisition, capital improvements) and decreased by depreciation or other allowable deductions.
  • Gain (or loss): amount realized minus adjusted basis.

Step-by-step: calculate basis and gain

  1. Establish the amount realized
  • Start with the gross selling price. Subtract direct selling costs (broker fees, escrow costs, advertising). Add any liabilities the buyer assumed and any non-cash consideration you received.
  1. Compute adjusted basis
  • For purchases: begin with the purchase price you paid for the business interests or assets. Add capital improvements and capitalized startup costs you later added. Subtract total depreciation or amortization you claimed (or were allowed) over the holding period. Include adjustments for casualty losses, insurance reimbursements, and prior dispositions. If you acquired the business by gift or inheritance, different basis rules apply.
  1. Allocate the price (asset sales)
  • If you sold business assets (common for sole proprietors), allocate the total price among asset classes: inventory, accounts receivable, equipment, real estate, and intangible assets (goodwill). The allocation affects tax character — goodwill typically produces capital gain; depreciable equipment may trigger recapture taxed as ordinary income.
  1. Calculate gain or loss
  • Gain = Amount realized – Adjusted basis. If greater than zero, you have a gain; if negative, a loss.

Reporting and tax character

  • Depreciation recapture: Gain attributable to depreciation on tangible personal property or certain intangibles is recaptured as ordinary income under Sections 1245 and 1250 rules and reported on Form 4797 (see IRS Form 4797 instructions) before any remainder may be treated as capital gain.
  • Capital gain vs ordinary income: After recapture, remaining gain from sale of capital assets held more than one year is long-term capital gain (preferential rates). Short-term results if held ≤ 1 year and taxed at ordinary rates.
  • Reporting forms: Typical forms include Form 4797 (sales of business property), Form 8949 and Schedule D (capital gains and losses), and Form 6252 for installment sales if you receive payments over time. (IRS reporting guidance)

Illustrative example (asset sale)

  • You sold a side service business for $30,000 and paid $2,000 in broker fees (amount realized = $28,000).
  • Your allocated assets: equipment with adjusted basis $6,000 (original cost $10,000 less $4,000 depreciation) and goodwill with adjusted basis $0.
  • Amount realized allocated to equipment = $8,000; to goodwill = $20,000 (allocation matters).
  • Equipment gain = $8,000 – $6,000 = $2,000. Because you claimed depreciation, that $2,000 is likely recaptured as ordinary income (Section 1245) and reported on Form 4797.
  • Goodwill gain = $20,000 – $0 = $20,000 capital gain. If you held the goodwill >1 year, this is long-term capital gain and taxed at capital gains rates.

Other situations to watch

  • Entity sales vs asset sales: Buying or selling stock (corporate shares) transfers basis differently than asset sales and generally results in capital gain or loss for the seller, not asset-level recapture. The buyer’s basis differs depending on structure; consider entity choice and consult a CPA or tax attorney.
  • Installment sales: If you accept payments over years, you may report gain over time using Form 6252, but depreciation recapture generally must be reported in the year of sale (exceptions apply).
  • Basis from inheritances and gifts: Assets received by gift or inheritance use special basis rules (carryover basis for gifts; stepped-up basis for most inherited property).

Practical recordkeeping and calculations

  • Keep originals or copies of purchase agreements, receipts for capital improvements, depreciation schedules (Form 4562), tax returns showing prior deductions, and closing documents showing selling costs.
  • Reconcile amortization or depreciation schedules to the adjusted basis you report. If you used the cash basis for business accounting, that affects timing of some items but not the basic basis formula.

Common mistakes and how to avoid them

  • Ignoring selling expenses: They reduce the amount realized and lower reported gain. Track broker fees, legal and escrow costs.
  • Misallocating purchase price: Poor allocation can trigger unnecessary recapture or misstate capital gain. Use a written allocation in the sales agreement.
  • Forgetting depreciation recapture: Treat depreciation recapture as ordinary income where required and report on Form 4797.

Timing and tax planning tips

  • Holding period: Holding qualifying assets more than 12 months can convert a portion of the gain to long-term capital gain with lower rates. (Long-term vs short-term rules)
  • Consider installment sales to spread income into lower-bracket years, but evaluate recapture and interest rules.
  • Coordinate sale timing with other income events to manage marginal tax rate and potential Net Investment Income Tax exposure.

Who should read this

  • Sole proprietors and microbusiness owners selling a side hustle
  • Partners and small S-corp or C-corp owners deciding between asset and equity sale structures
  • Anyone who has claimed depreciation and is selling depreciable business property

FAQs (short)

  • Do selling expenses affect gain? Yes — subtract allowable selling expenses from the gross selling price when computing amount realized.
  • Is depreciation recapture always taxed as ordinary income? Generally yes for Section 1245 property; specific rules differ for real property (Section 1250) and require review.
  • What if I sell at a loss? Losses on personal-use assets are usually nondeductible; business asset losses may be deductible and can offset other gains.

Professional tips

  • Create a spreadsheet that tracks original cost, capital improvements, depreciation taken each year, and computed adjusted basis for each asset class.
  • Include a written allocation schedule in the purchase agreement to avoid future disputes and to support your tax return if the IRS asks.
  • Early in the sale process, consult a CPA familiar with small-business sales and the appropriate forms: Form 4797, Form 8949/Schedule D, and Form 6252 for installment sales.

Internal resources

Authoritative sources and where to read more

  • IRS Publication 544, Sales and Other Dispositions of Assets (IRS)
  • IRS: Reporting Capital Gains and Losses for Individuals and Businesses (IRS)
  • IRS Form 4797 Instructions (sales of business property) and Form 6252 (installment sale)

Professional disclaimer
This article is educational and not individualized tax or legal advice. Tax rules are fact-specific and change; consult a licensed CPA or tax attorney to apply these concepts to your sale.

Last reviewed: 2025 (sources checked for current forms and guidance).