Follow KBKG on Social Media
By Malik Javed | Principal, Cost Segregation
Owners of rental or commercial real estate have likely claimed depreciation deductions on their tax returns. While these deductions provide annual tax savings, upon sale of the property, the IRS may recapture some of those savings through a provision known as Depreciation Recapture. Many property owners are unprepared for this tax, but understanding how it works in advance allows for better planning and helps avoid unexpected surprises.
KBKG Insight:
Depreciation Recapture can be viewed as the IRS’s way of ‘settling the score.’ While depreciation generates tax savings during the period of ownership, the IRS requires repayment of a portion of those benefits if the property is sold at a gain. The positive news is that, with proper planning, the amount of recapture owed can be reduced.
What Is Depreciation Recapture?
When a property is sold for more than its depreciated value (referred to as the adjusted basis), the IRS may ‘recapture’ a portion of the depreciation deductions previously claimed. Rather than taxing the entire gain at favorable capital gains rates, the IRS separates the depreciation portion and taxes it differently:
- Section 1250 Property (Structural Components): Recaptured at a maximum rate of 25%.
- Section 1245 Property (Personal Property like carpet, cabinets, and equipment): Recaptured at your ordinary income tax rate (up to 37%).
Depreciation Recapture in Action
Here are two examples (one with Cost Segregation and one without) with calculations that illustrate how recapture tax applies.
Scenario 1: Without Cost Segregation
- Purchase Price: $2,000,000
- Depreciation Claimed on Structure: $300,000
- Adjusted Basis: $1,700,000 (purchase price minus depreciation claimed)
- Sale Price: $3,000,000
- Total Gain: $1,300,000 (sale price minus adjusted basis)
|
Item
|
Amount
|
Rate
|
Tax Due
|
|---|---|---|---|
|
Depreciation Recapture for the Structure (27.5 or 39 year property) |
$300,000 |
25% |
$75,000 |
|
Remaining Gain (Captial Gain) |
$1,000,000 |
20% |
$200,000 |
|
Total Tax |
|
|
$275,000 |
Without Cost Segregation, $300k of depreciation on the building is subject to recapture (at 25%) and the rest of the gain at 20%, for a total tax of $275k.
Scenario 2: With Cost Segregation
Now assume the taxpayer performed a Cost Segregation study, which allowed accelerated depreciation and resulted in $700,000 in deductions during the same period. This included $500,000 of Section 1245 personal property (5-year) and $200,000 of 27.5 or 39-year real property.
- Purchase Price: $2,000,000
- Adjusted Basis: $1,300,000
- Sale Price: $3,000,000
- Total Gain: $2,000,000
|
Item
|
Amount
|
Rate
|
Tax Due
|
|---|---|---|---|
|
Depreciation Recapture (1245) |
$500,000 |
35% |
$175,000 |
|
Depreciation Recapture (1250) |
$250,000 |
25% |
$50,000 |
|
Remaining Gain (Captial Gain) |
$1,000,000 |
20% |
$200,000 |
|
Total Tax |
|
|
$425,000 |
Side-by-Side Comparison
|
|
Without Cost Segregation
|
With Cost Segregation
|
|---|---|---|
|
Depreciation Claimed During Ownership |
$300,000 |
$700,000 |
|
Recapture Tax Paid on Sale |
$75,000 |
$250,000 |
|
Capital Gains Tax Paid |
$200,000 |
$200,000 |
|
Total Tax |
$275,000 |
$450,000 |
This scenario results in $450,000 of total tax, which is $175,000 more than the $275,000 in the first scenario. At first glance, Cost Segregation appears to increase the tax liability upon sale. However, it is important to note that Cost Segregation provided $400,000 more in depreciation ($700,000 vs. $300,000) during ownership, resulting in significant tax savings in earlier years. The benefit of Cost Segregation lies in its timing advantage. Tax savings are realized upfront, with some tax effectively deferred until the time of sale, benefiting from the time value of money.
Strategies to Manage Recapture
While recapture on legitimate depreciation cannot be avoided, unnecessary recapture can be minimized by properly handling certain expenses and asset disposals:
- Retire Assets When Removed: When a building component is removed or replaced (for example, a roof or HVAC system), the remaining undepreciated value of the old component should be written off in that year as a partial disposition. Continuing to depreciate an asset that no longer exists results in recapture tax upon sale, effectively creating tax on phantom assets.
- Expense Real Repairs: If an item that should have been expensed as a repair or maintenance cost was instead capitalized and depreciated, unnecessary depreciation was created. This also leads to extra recapture tax upon sale. Correctly identifying and expensing repairs in accordance with IRS repair regulations prevents unnecessary recapture.
- Use Cost Segregation to Identify Retirements and Repairs: A detailed Cost Segregation study, particularly when paired with a fixed asset review, can uncover components that were disposed of or should have been expensed. By making these adjustments, claiming losses for retired assets and taking deductions for misclassified repairs, the amounts will not be subject to recapture at the time of sale. This ensures that more of the gain qualifies for lower capital gains rates rather than higher recapture rates, providing permanent tax savings rather than a deferral.
- Use a 1031 Exchange to Defer Taxes: A properly executed 1031 Exchange allows both capital gains and recapture taxes to be deferred by reinvesting in another property.
Conclusion
Depreciation recapture is simply paying back part of the tax benefits you received during ownership. It doesn’t mean depreciation was a bad deal, as the upfront savings often outweigh the later tax cost, thanks to the time value of money. By understanding how recapture works and planning ahead, property owners can enjoy the benefits of depreciation while keeping future taxes manageable.
About the Author
Malik Javed | Principal – Cost Segregation
Malik S. Javed is a Principal and oversees engineering operations for Cost Segregation projects at KBKG. He is a Certified member of the American Society of Cost Segregation Professionals (ASCSP) and is currently a member of the ASCSP Technical Standards Committee. Since joining KBKG in 2004… Read More