Depreciation Recapture, Explained

Cost segregation accelerates your deductions, which raises a fair question: what happens when you sell? The answer is depreciation recapture. It sounds like a catch, and it is a real trade-off, but for most owners a study still comes out ahead. Here is the plain-English version, and the honest cases where it does not.

What recapture actually is

When you sell a property for a gain, you might assume the whole gain gets long-term capital gains treatment. Recapture is the rule that says otherwise. The portion of your gain that is attributable to the depreciation you already took is taxed separately, rather than getting that favorable long-term rate. In other words, the IRS lets you deduct depreciation while you hold the property, then, at sale, recovers tax on the value those deductions represented. Recapture is not a penalty for doing something wrong; it is simply the other side of having taken the deductions in the first place.

The two buckets at sale

Recapture is not one thing. For a building that has had a cost segregation study, the gain attributable to depreciation generally splits into two buckets that are treated differently.

The first bucket is personal property and land improvements, the 5, 7, and 15-year items a study reclassifies. These are Section 1245 property. The depreciation taken on them is recaptured as ordinary income to the extent of that depreciation, meaning it is taxed at your ordinary income rates rather than capital gains rates.

The second bucket is the building structure itself, which is Section 1250 real property. The depreciation taken on the structure is generally treated as "unrecaptured Section 1250 gain," which for most taxpayers is taxed at a maximum federal rate of 25%, instead of receiving full long-term capital gains treatment. The exact split, and how each bucket applies to you, is something your CPA determines from your specific facts.

How cost segregation affects recapture

This is where the trade-off lives. A cost segregation study deliberately shifts more of your basis out of the slow 39-year building shell and into 1245 personal property, and it accelerates the deductions you take. Because you took larger and faster deductions, there is more depreciation sitting in that 1245 bucket, and potentially more to recapture at ordinary income rates when you sell. So yes, in general terms, accelerating depreciation can increase the amount recaptured at sale. That is the honest part of the picture, and a good provider says it out loud.

Why it is usually still worth it

Recapture rarely erases the benefit. Three things tend to keep a study worthwhile even after accounting for it.

• The time value of money. A deduction today is worth more than the same deduction spread over decades. Putting cash back in your hands now, to reinvest or pay down debt, generally outweighs settling up later.
• A 1031 like-kind exchange. If you reinvest the proceeds into qualifying replacement property, a 1031 exchange can defer the gain, including the recapture, rather than triggering it at sale.
• Rate and timing differences. Many owners are in a higher tax bracket while operating the property than they expect to be at a planned sale, or they simply hold for the long term, which softens or delays the recapture math.

None of these are guarantees, and the relevant rates and rules can change. They are reasons the trade-off usually favors acting, not a promise about your specific outcome.

When it might not be worth it

Cost segregation is genuinely not for everyone. A study can be a poor fit if you plan to sell soon and do not intend to use a 1031 exchange, if you expect to be in a higher bracket at sale than while you operate, or if the projected benefit simply does not clear the cost of the study. In those situations, pulling deductions forward can create recapture that outweighs the advantage. Honesty here is the whole point. A good provider tells you when recapture makes a study the wrong move, rather than selling you one anyway.

The honest bottom line

Recapture is a real consideration, not a reason to walk away by default. For most commercial owners who hold for a reasonable period, or who plan to exchange rather than cash out, the time value of accelerated deductions still wins. But the only way to know your answer is to have your CPA model your specific hold period, tax bracket, and exit plan. That modeling is what turns "it depends" into a decision you can stand behind.

Frequently asked questions

Does cost segregation increase my taxes when I sell?

It can increase the amount of gain recaptured at sale, because a study shifts more of your basis into shorter-life personal property and accelerates deductions. Whether that makes a study a poor fit depends on your hold period, your tax bracket, and your exit plan, which only your CPA can model for your situation.

What is unrecaptured Section 1250 gain?

It is the portion of gain on the building structure (Section 1250 real property) that is attributable to depreciation you took. For most taxpayers it is taxed at a maximum federal rate of 25%, rather than receiving full long-term capital gains treatment. Your CPA determines how it applies to you.

Can a 1031 exchange defer recapture?

A 1031 like-kind exchange can defer the gain, including recapture, when you reinvest the proceeds into qualifying replacement property within the required rules and timelines. The rules are specific and exacting, so coordinate any exchange with your CPA and a qualified intermediary before you sell.

When should I NOT do a cost segregation study?

Cost segregation is not for everyone. It may be a poor fit if you plan to sell soon without a 1031 exchange, expect a higher bracket at sale than while operating, or the benefit does not clear the cost. The only way to know is to have your CPA model your hold period, bracket, and exit plan first.

Sources

» Internal Revenue Code Section 1245, gain from dispositions of certain depreciable property
» Internal Revenue Code Section 1250, gain from dispositions of certain depreciable realty
» Internal Revenue Code Section 1031, like-kind exchanges
» IRS Publication 544, Sales and Other Dispositions of Assets
» IRS Cost Segregation Audit Techniques Guide