Franchise Depreciation Recapture: The Bill Most Sellers Never See Coming

You already know depreciation lowers a franchise unit's tax bill every year you own it. What most sellers never work out until the purchase agreement is on the table is that the IRS wants a share of that deduction back the moment the unit changes hands, in cash, sometimes at a rate higher than the tax bracket that generated the original write-off. That clawback is franchise depreciation recapture, and it is one of the largest, least-anticipated costs in a franchise unit sale, one that more owners are about to run into: franchise resales climbed 62.7 percent year over year through the third quarter of 2025 even as broader small-business transaction counts fell, and the transfer rate across franchised units hit 4.1 percent in 2024, the highest mark in five years.

What depreciation recapture actually is

Depreciation lets an owner deduct the wear and use of a building, its improvements, and its equipment against income each year the unit operates. The IRS treats that deduction as a loan rather than a gift. When the unit sells for more than its depreciated basis, the portion of the gain equal to the depreciation already claimed gets taxed back, separately from ordinary capital gains treatment on any appreciation above the original purchase price.

Two different rules apply, and which one hits harder depends on what generated the deduction. Section 1250 covers real property, meaning the building and structural improvements, and caps recapture at a 25 percent federal rate on the unrecaptured gain. Section 1245 covers personal property, meaning equipment, signage, kitchen hardware, and point-of-sale systems, and recaptures at ordinary income rates, which run as high as 37 percent in 2026. Most franchise operators know one of these rules exists. Almost none of them know which one applies to which line item on their own depreciation schedule.

The math on a real franchise unit sale

Run the numbers on a straightforward sale. A franchisee buys a unit for 600,000 dollars: 400,000 for the building and improvements, 150,000 for equipment and fixtures, 50,000 for non-depreciable land. Over six years of ownership, a cost segregation study and bonus depreciation let the owner claim roughly 120,000 dollars of depreciation on the equipment and fixtures, taxed as Section 1245 property, plus 60,000 dollars of straight-line depreciation on the building, taxed as Section 1250 property. The unit sells for 950,000 dollars.

The Section 1245 recapture, taxed at ordinary income rates up to 37 percent, runs as high as 44,400 dollars. The Section 1250 recapture, capped at 25 percent, adds another 15,000 dollars. That is roughly 59,400 dollars in federal recapture tax alone, before state tax, before net investment income tax, and before any capital gains due on appreciation above the original 600,000 dollar basis. Sellers who model a deal off the sale price and their loan payoff routinely miss this number entirely, because it never appears on a listing sheet or a broker's valuation summary.

Why a cost segregation study makes the recapture bill bigger, not smaller

A cost segregation study is one of the most common ways franchise operators cut their tax bill in the early years of ownership. It reclassifies portions of a build-out from 39-year real property into 5-, 7-, and 15-year personal property that depreciates far faster. Paired with the 100 percent bonus depreciation now written permanently into law for property placed in service after January 19, 2025 under the One Big Beautiful Bill Act, an operator can write off the reclassified assets almost entirely in year one.

That study lowers taxable income while the unit is owned. It does not lower total depreciation claimed, and it does not change what eventually gets recaptured. It shifts a larger share of the future bill into Section 1245, taxed at ordinary income rates, instead of leaving it under the 25 percent cap that applies to Section 1250 real property. An operator who orders a cost segregation study to save 70,000 dollars in year-one taxes and sells five years later can end up with an ordinary-income recapture bill larger than it would have been without the study. The study is still usually worth doing. It just needs to be underwritten as a deferral, not a permanent savings.

The 1031 exchange workaround, and where it stops working

A Section 1031 like-kind exchange lets an owner defer recapture and gain by rolling proceeds from real property into other real property held for business or investment use. It is the tool most sellers reach for first. It also covers far less of a franchise sale than most sellers assume. Tax reform passed in 2017 eliminated 1031 treatment for personal property, so the equipment, fixtures, signage, and point-of-sale systems inside a unit no longer qualify for exchange under any circumstance.

In a large share of franchise deals, the operator does not even own the real estate: a landlord holds title and the franchisee leases the space, which means there is no real property to exchange in the first place. Where the operator does own the building, a 1031 exchange only defers the Section 1250 portion of recapture. The Section 1245 recapture on equipment is due in the year of sale regardless of what happens to the real estate.

Installment sales and entity structure change the timing, not the total

An installment sale under Section 453 can spread the capital gains portion of a deal across the years payments arrive, which helps smooth a seller's tax bracket. Depreciation recapture does not get that treatment. It must be reported and taxed in the year of sale regardless of when the buyer's payments show up, even on a note structured over five years. A seller who assumes recapture spreads out along with the payment schedule ends up owing tax on cash they have not collected yet.

How the unit is held also matters more than most sellers realize, and it matters to a growing share of the franchise world: operators who run multiple units now account for 19.3 percent of all franchisees and control 58.8 percent of franchised locations, which means most resale decisions today involve a holding company structure, not a single owner selling their only unit. A single-member LLC, an S-corp, and a multi-unit holding company each route recapture income differently, and each carries different exposure to the 3.8 percent net investment income tax and to state-level treatment that does not always mirror the federal 25 percent cap. That structuring decision needs to happen with a CPA before a letter of intent goes out, not during a 30-day due diligence window after a buyer is already at the table.

What to calculate before a unit goes on the market

Pull the fixed asset ledger from the original cost segregation study and separate what was classified as Section 1245 property from what stayed Section 1250. Estimate the ordinary-income share of the gain against current federal rates and the capital-gains share against the 25 percent cap, then layer in the state tax treatment for wherever the unit sits. Confirm whether the real estate is even owned by the selling entity, because that answer decides whether a 1031 exchange is available at all. Franchise networks that track unit-level financials in one place, the kind of consolidated reporting Revscale's franchise intelligence platform provides, can pull that basis breakdown in minutes instead of reconstructing six years of depreciation schedules during due diligence.

The number that decides what a seller actually keeps is not the price on the letter of intent. It is the adjusted basis sitting on the depreciation schedule, and the seller who does not know that number before signing is the one who finds out what franchise depreciation recapture costs at the closing table instead of before it.