Cost Segregation and Depreciation Recapture: what happens when you sell

What is Depreciation Recapture?

Depreciation reduces your tax basis in a property. When you sell for more than that reduced basis, the IRS "recaptures" some of the Depreciation you claimed by taxing part of the gain differently from ordinary capital gains:

• The building itself (Section 1250 property): gain attributable to straight-line Depreciation is "unrecaptured Section 1250 gain", taxed at a maximum federal rate of 25%.
• Personal property identified by a study (Section 1245 property): gain up to the Depreciation claimed is taxed as ordinary income.
• Land improvements: where they were depreciated faster than straight-line, part of the gain can also be treated as ordinary income.

Why a study is usually still worth it

• Time value of money: a deduction today is worth more than a Tax Bill years from now. The cash you keep can pay down debt, fund improvements or buy the next property.
• Recapture is limited to the gain on those assets: Section 1245 recapture is the lower of the Depreciation claimed and the gain on those specific components. Ten-year-old carpet, fixtures and finishes are rarely worth what they cost, and a supportable allocation of the Sale Price reflects that.
• Rate differences: owners often deduct at a high marginal rate during peak earning years and sell when their income, and rate, is lower.
• You may never pay it: exchanges and a Step-Up in Basis at death can defer or eliminate recapture entirely.

Five ways to manage Recapture

1. Hold for the long term

The longer you hold, the longer the tax stays deferred, and the less your short-life components are typically worth at sale.

2. Use a 1031 Exchange

Exchanging into like-kind real property defers capital gain and Section 1250 recapture. Section 1245 components need care, because recapture can be triggered if the replacement property doesn't include enough comparable property. Structure the exchange and the allocation together.

3. Allocate the Sale Price properly

The price you sell for should be allocated between land, building and personal property based on fair values. A Cost Segregation study gives you the starting point to support a realistic allocation rather than a default one.

4. Plan for Step-Up in Basis

Property held until death generally receives a stepped-up basis for heirs, which can eliminate recapture altogether. For long-term family holdings, this can make accelerated Depreciation close to a permanent saving.

5. Write off what you replace

When components are removed during renovations, a Partial Disposition can write off their remaining basis, so you aren't carrying (and later recapturing) Depreciation on assets that no longer exist.

A note on Installment Sales

Seller financing can spread capital gain over several years, but Depreciation Recapture taxed as ordinary income is generally recognized in the year of sale, even if most of the cash arrives later. Factor that into any installment sale.

Frequently asked questions

This article is general information, not tax, legal or accounting advice. Tax rules change and outcomes depend on your specific facts; speak with a qualified tax professional before acting.