Cost Segregation · Brief · Working level
Depreciation recapture after cost segregation: the bill that comes due at sale
Sections 1245 and 1250 tax prior depreciation when a building sells — at up to 37 percent ordinary rates for reclassified personal property and a 25 percent cap for the building itself. How cost segregation changes the character of gain, with the rate arithmetic.
Cost segregation front-loads deductions; recapture is where the tab is settled. When a building sells at a gain, the Code does not let prior depreciation convert into capital gain quietly. Section 1245 recaptures depreciation on personal property — including everything a study reclassified to 5-, 7-, or 15-year lives* — as ordinary income, at rates up to 37 percent. Section 1250, for the building itself, recaptures only depreciation in excess of straight line (which, under MACRS, is none), but the straight-line depreciation still surfaces as unrecaptured Section 1250 gain, taxed at a maximum 25 percent for individuals. (*Technically, 15-year land improvements are Section 1250 property, but because they are depreciated on an accelerated method, the excess over straight line is recaptured as ordinary income — in practice they sit between the clean categories.)
The practical consequence: a cost segregation study moves future gain out of the 25-percent-capped bucket and into the ordinary bucket. Whether the interim deferral outruns that rate spread is the central economic question of the strategy.
The three layers of gain
Sale proceeds are allocated among the assets sold (the study's component detail does this work), and each asset's gain stacks in layers:
- Section 1245 ordinary income — gain up to total depreciation claimed on personal-property components, including bonus. Ordinary rates, up to 37 percent, plus state.
- Unrecaptured Section 1250 gain — gain up to the straight-line depreciation on the building, taxed at a maximum 25 percent (Section 1(h)(6)).
- Residual long-term capital gain — anything beyond, at 0/15/20 percent.
The 3.8 percent net investment income tax can ride on top of all three layers for passive owners.
The rate arithmetic, worked
Assume $1,000,000 of depreciable basis, 25 percent reclassified, fully depreciated via bonus at acquisition, building depreciated straight-line for 10 years, then the property sells for a gain exceeding all depreciation.
Character of depreciation-related gain, with and without a study (37% ordinary rate, 25% §1250 rate):
| Item | No study | With study |
|---|---|---|
| Straight-line building depreciation | $256,000 | $192,000 |
| §1245 depreciation (bonus on reclassified 25%) | $0 | $250,000 |
| Tax on recapture layers at sale | $64,000 | $140,500 |
| Tax deferred in year one (37% × $250,000 bonus) | — | $92,500 |
The study produced $92,500 of year-one deferral but roughly $76,500 of additional tax at sale — the taxpayer keeps the spread plus ten years' use of the money. Compress the hold to three years and the use-of-money value shrinks while the recapture cost does not; that asymmetry is the core of when cost segregation doesn't make sense. (The table simplifies: the with-study building depreciation is smaller because basis moved out of the 39-year class, and actual §1245 gain is limited to gain allocated to those components.)
What softens or defers the bill
- Allocation and appraisal. Section 1245 recaptures gain on those components. Five-year-old carpet and equipment may genuinely be worth little at sale; a supportable purchase price allocation assigning them modest value limits ordinary recapture. Unsupported allocations invite Section 1060 scrutiny from both the IRS and the buyer, whose interests are adverse.
- Section 1031 exchanges defer the gain and carry the recapture attribute into the replacement property — deferral, not escape, with complications noted in our anti-pitch piece.
- Death. The basis step-up under Section 1014 extinguishes unrealized recapture entirely; for hold-till-death owners, the deferral is permanent.
- Released passive losses. A fully taxable disposition releases the activity's suspended Section 469 losses, which offset the recapture income — often the quiet reason the exit-year return looks better than feared.
- Partial dispositions along the way. Components replaced during ownership and written off via partial disposition elections are no longer around to recapture, and the election avoids depreciating a roof that went to the landfill.
None of this makes recapture an argument against cost segregation generally — deferral has real value, and several exits neutralize the bill. It is an argument for pricing the strategy honestly: the year-one deduction is a loan, and Sections 1245 and 1250 are the repayment schedule. For the depreciation fundamentals underneath all of this, see depreciation basics.
Frequently asked questions
- What is depreciation recapture when you sell a building?
- On sale, gain attributable to prior depreciation is taxed under special rules: depreciation on Section 1245 personal property (the components a cost segregation study reclassified) is ordinary income up to a 37 percent federal rate; straight-line depreciation on the building itself is unrecaptured Section 1250 gain, capped at 25 percent. Only gain beyond total depreciation gets long-term capital rates.
- Does cost segregation increase depreciation recapture?
- It changes its character and often its rate. Total depreciation — and thus total recapture exposure — is similar either way, but cost segregation shifts deductions from the 25-percent-capped Section 1250 category into Section 1245 property, whose recapture is ordinary income at up to 37 percent. The deferral benefit must outrun that rate spread for the study to pay.
- Can you avoid depreciation recapture?
- Defer it with a Section 1031 exchange (the attribute carries into the replacement property), eliminate it at death via the basis step-up, or absorb it with suspended passive losses released on sale. Selling components for their actual depreciated value, supported by an appraisal, can also limit Section 1245 gain. It cannot simply be elected away.