Depreciation recapture and cost segregation

What recapture is

Every depreciation deduction reduces your adjusted basis in the property. When you sell, gain is measured against that lower basis, so part of the gain exists only because of depreciation you took. The tax code treats that portion differently from ordinary capital gain, and the treatment depends on the type of property.

• §1245 property. This is the personal property a study identifies, such as 5- and 7-year components. On a sale, gain up to the depreciation taken on that property is recaptured and taxed as ordinary income.
• §1250 property. This is the building and most land improvements. Gain attributable to straight-line depreciation on real property is generally taxed as unrecaptured §1250 gain, at a capped rate. Depreciation in excess of straight line, such as accelerated or bonus depreciation on land improvements, can be recaptured as ordinary income.

How these rules apply depends on the asset, the taxpayer and the structure of the sale, which makes the final answer a question for your CPA. What a study does is give your CPA the component detail to answer it accurately.

Skipping a study does not avoid recapture

Recapture is based on depreciation that was "allowed or allowable." If depreciation was allowable and you did not claim it, your basis is still reduced as if you had. An owner who skips a study to avoid recapture still faces tax on the straight-line depreciation they were entitled to at sale, and gives up the acceleration that made the deductions valuable in the first place.

If you have owned a property for years without claiming all the depreciation it allowed, a look-back study can catch up the missed amount in the current year through Form 3115, without amending prior returns.

Why acceleration still makes sense

A study changes when you take deductions, not how much you deduct over the life of the property. The value comes from the time between the deduction and any recapture: cash that stays in your hands, or goes into operations, debt paydown or the next acquisition, for every year you hold. The longer the hold, the more that deferral is worth. Depending on your situation, the rate at which the deductions offset income and the rate applied to recapture can also differ, which your CPA can model for your facts.

Ways to manage recapture

• Partial asset dispositions. When you replace a roof, an HVAC unit or a tenant build-out, a partial disposition election writes off the retired component's remaining basis in the year you remove it. Without the election, the old component stays on the books, keeps depreciating alongside its replacement, and adds to the depreciation exposed to recapture at sale. How partial dispositions work.
• Holding period. Recapture weighs most heavily against the benefit when a property is sold soon after a study. Plan the hold and the study together.
• Exchange planning. A §1031 exchange can defer gain on real property, but §1245 recapture can still surface where §1245 property is not matched on the replacement side. 1031 exchanges and cost segregation.
• Allocation at sale. How the sale price is allocated among land, building and components affects how gain is characterized. The component detail from a study supports a documented allocation, worked out with your CPA.
• Accurate records. A fixed asset and depreciation schedule review, coordinated with your CPA, finds assets that were retired but never written off, and components that were never separated.

Questions to bring to your CPA before a sale

• How much of the gain on this property will be §1245 recapture, how much unrecaptured §1250 gain, and how much capital gain?
• Are there retired components still on the depreciation schedule that should have been written off?
• Would an exchange defer the gain, and would any §1245 recapture surface in it?
• How should the sale price be allocated among land, building and components, and is that allocation documented?
• Would a different hold period, or a different exit structure, change the answer materially?

The component detail from an engineered study is what lets your CPA answer each of these with figures rather than assumptions. If the property was never studied, or the schedule has not been reviewed in years, a schedule review before the sale is a sensible first step.

Recapture and the original study

The quality of the original study matters at exit as much as it did on the return where the deductions were first claimed. A study that cannot show how a component was classified, or what it cost, leaves your CPA guessing when the gain is characterized. An engineered study, signed off by the Head of Engineering and backed by lifetime audit defense for the taxpayer and the property while under their ownership, gives the exit the same support the deductions had.

What recapture does not change

Recapture does not undo the years of cashflow a study produced, and it does not make an engineered study less valuable. It makes the study one part of a plan that runs from acquisition to exit. Investors who understand recapture at the start tend to choose their hold periods, their exit structures and their replacement properties with it in mind, and that is where the planning value lies.