Overview

When you sell a business (or its assets), the taxable gain or loss depends not just on the sale price but on each asset’s adjusted tax basis. The adjusted basis starts with what you paid (cost basis), adds capital improvements, and subtracts depreciation, casualty losses, and other reductions. Accurate basis adjustments are essential because they determine capital gain, depreciation recapture, and whether parts of the sale are ordinary income or capital gain.

This article explains the mechanics, common pitfalls, record-keeping, and practical strategies to manage tax basis adjustments after a business sale. It includes links to FinHelp resources that dive deeper into basis step-ups and correcting basis errors.

Why basis adjustments matter

  • Capital gain (or loss) on each asset = amount realized for that asset − adjusted basis. The “amount realized” can include cash, liabilities assumed by the buyer, and noncash property received.
  • Depreciation recapture can recharacterize what would otherwise be capital gain into ordinary income to the extent of prior depreciation (see IRS Publication 544 and guidance on depreciation recapture).
  • Buyers often want a higher post-acquisition basis (a step-up) for the assets they purchase; sellers need to understand how allocation affects their tax outcome and reporting obligations.

Authoritative sources: IRS Publication 551 (Basis of Assets) and IRS Publication 544 (Sales and Other Dispositions of Assets) explain these rules and examples (irs.gov/publications/p551; irs.gov/publications/p544). When an asset sale accompanies a business purchase, both buyer and seller normally must file Form 8594 to report the allocation of the purchase price (see: irs.gov/forms-pubs/about-form-8594).

Key rules and common adjustments

  1. Starting point: cost basis
  • Cost basis is what you paid for the asset (including purchase price, sales tax, shipping, and setup costs). For property you built or improved, include the cost of materials and labor.
  1. Adjustments up (increase basis)
  • Capital improvements that add value or extend life (e.g., major renovations) increase basis.
  • Certain acquisition costs may increase basis for the buyer’s tax accounting; for sellers, transaction costs (broker commissions, legal fees) typically reduce amount realized rather than increase basis, so handle carefully.
  1. Adjustments down (decrease basis)
  • Depreciation, Section 179 deductions, and amortization reduce the basis. This reduction is what creates depreciation recapture on sale.
  • Casualty or theft losses previously claimed also reduce basis.
  1. Depreciation recapture (Sections 1245 and 1250)
  • For personal property and certain intangible amortizable assets, Section 1245 recapture can convert gain into ordinary income up to the amount of prior depreciation allowed or allowable.
  • For real property, Section 1250 applies; generally, additional depreciation recapture rules may apply depending on the depreciation method used. Refer to IRS Pub 544 for worked examples.
  1. Allocation of purchase price (Form 8594)
  • In an asset sale, buyer and seller must allocate the total purchase price among asset classes (tangible, intangible, goodwill) using agreed categories and report the same allocation on Form 8594. Mismatched allocations between buyer and seller can trigger IRS inquiries.
  1. Liabilities and amount realized
  • If the buyer assumes liabilities (e.g., debt), those amounts generally increase the seller’s amount realized and therefore can increase taxable gain. Include the tax treatment of assumed liabilities in planning and sales agreements.
  1. Installment sales (Section 453)
  • Selling on an installment basis spreads recognition of gain as payments are received. Basis is recovered first; however, depreciation recapture may be recognized in the year of sale for certain assets even when payments are postponed. Consult a tax pro for timing and reporting specifics.
  1. Special situations: stock sales vs. asset sales
  • In a stock sale, the buyer gets the seller’s inside basis unchanged; the seller’s stock basis determines gain on sale. Asset sales allow buyers to step up basis in the acquired assets, which buyers like because of future tax deductions. Sellers often prefer stock sales for simpler tax results (and potential capital gains treatment), but the choice affects how basis adjustments are handled.
  • For pass-through entities (partnerships, S corporations), basis rules for the sellers (partners’ outside basis or shareholders’ stock basis) introduce additional layers—unrealized receivables and inventory items can be recharacterized under Section 751 in partnership sales.

Practical example (simplified)

You sell equipment you bought for $50,000. Over time you claimed $20,000 in depreciation, so the adjusted basis is $30,000. If the buyer pays $60,000 for that equipment, your gain = $60,000 − $30,000 = $30,000. If the $20,000 depreciation was claimed under rules subject to Section 1245, up to $20,000 of that gain may be recaptured as ordinary income; the remaining $10,000 may be capital gain.

If the sale included assumed liabilities or an allocation that puts additional value on intangible assets (goodwill), those items will be allocated and taxed differently. Both parties must file Form 8594 with the agreed allocation; inconsistent allocations can cause audits.

Step-by-step checklist before closing

  1. Inventory all assets and confirm documentary evidence of purchase price, improvements, and depreciation schedules.
  2. Obtain current fair market value (FMV) appraisals for major assets—real estate, customer lists, or specialized equipment.
  3. Decide early whether the sale will be treated as a stock sale or an asset sale; negotiate allocation in the purchase agreement.
  4. Model price allocation scenarios to show seller tax consequences (capital gain vs. ordinary income via recapture) and buyer benefits (basis step-up).
  5. Consider timing mechanisms: installment sale, deferred payments, or escrow arrangements and how they affect recognition and basis recovery.
  6. Prepare to file required forms (Form 8594 for asset allocation) and preserve documentation for at least the statute of limitations plus the asset’s recovery period (often 3–7 years, but keep longer for major capital items).

Common mistakes and how to avoid them

  • Failing to allocate purchase price correctly: Work with appraisers and your buyer to reach a defensible allocation and document the methodology.
  • Overlooking depreciation recapture: Review prior depreciation schedules and anticipate recapture as ordinary income. This is often the largest tax surprise for sellers.
  • Poor record-keeping: Missing invoices, records of improvements, or depreciation computations make substantiation difficult during IRS inquiries.
  • Ignoring state tax effects: State tax rules can differ. Confirm state-level treatment with a CPA or tax attorney.

Strategies that can reduce tax surprise

  • Negotiate allocation: Sellers can negotiate more value to flow to assets that produce capital gain rather than recapture, but buyers resist because they prefer allocations that give them a higher basis in depreciable property.
  • Use installment sales wisely: For certain sales, spreading gain recognition can improve cash flow and tax planning.
  • Pre-sale tax planning: Accelerate or delay deductions, adjust depreciation elections, or consider entity-level planning to change the character of the sale.
  • Consider a 1031 exchange for qualifying real property (rules have narrowed after 2017 to real property only) if you plan to reinvest proceeds into similar property (see IRS guidance on like-kind exchanges).

In my practice, early engagement with a CPA and tax attorney during deal structuring reduces last-minute tax surprises and often lowers aggregate tax costs.

Documentation and reporting

  • Form 8594: Allocation of the purchase price among asset classes must be reported by both buyer and seller in an asset sale.
  • Schedule D/Form 8949: Capital gains and losses flow to these forms; depreciation recapture may need to be reported as ordinary income on Form 4797.
  • Retain purchase invoices, depreciation schedules, repair vs. improvement analyses, and appraisal reports.

Links to related FinHelp content

Frequently asked questions (brief)

Q: Do I report an allocation if we signed an asset purchase agreement but later close as a stock sale?
A: No—allocations apply to the actual tax form of the sale. However, the sale structure should be decided and documented early because negotiating price and representations depends on whether you sell assets or stock.

Q: Does depreciation recapture always apply?
A: Not always. It applies to the extent depreciation, Section 179, or amortization was claimed on assets sold and when those assets are subject to recapture rules (e.g., Section 1245 for personal property).

Q: How long should I keep records?
A: Keep supporting records at least as long as the statute of limitations for the year of sale (typically three years), but for basis documentation and depreciation recapture issues you should retain records for the life of the asset and longer for major transactions.

Professional disclaimer

This article is educational and does not replace personalized tax advice. Tax law is complex and fact-specific; consult a qualified CPA, tax attorney, or financial advisor before making decisions. IRS publications cited include Publication 551 and Publication 544, and you can find Form 8594 instructions on IRS.gov.

Authoritative sources

Additional helpful resources include Tax Foundation and Investopedia for general background on basis and capital gains.