One of the biggest arguments I see around cost segregation studies is the issue of depreciation recapture upon the sale of the property. Do the benefits of the cost segregation study outweigh the cost of recapture? As with most tax strategies, it depends. Those who see the most benefit are typically the ones consistently updating their tax planning and implementing new strategies.
What is cost segregation?
A cost segregation study is a federal income tax tool that increases your near-term cash flow by deferring taxes. Instead of depreciating the entire purchase price over 27.5 or 39 years, it reclassifies property into their applicable useful lives such as 5, 7 or 15 years which accelerates the amount of depreciation that can be taken further reducing your taxable income.
What is depreciation recapture?
Depreciation recapture is the process the IRS uses to collect taxes on the gain you've made from the sale of your real estate property (Section 1250) or personal property (Section 1245) and to recover the benefits you received by using the depreciation expense to reduce your taxable income. Section 1250 is taxed at your ordinary tax rate up to 25% and Section 1245 is taxed at your ordinary tax rate.
Here is a simplified example of depreciation recapture.
You purchased a residential rental property for $750,000. The land is valued at $50,000, so your depreciable basis is $700,000. You elected to use straight line depreciation or $25,454/year ($700,000 / 27.5 years). After 5 years of owning the property, you decide to sell it for $1,000,000. The depreciation subject to recapture is $127,270 ($25,454 x 5). Your adjusted cost basis is $622,730 ($750,000 - $127,270). You have a realized gain of $377,270 ($1,000,000 - $622,730) which is split between depreciation recapture and capital gains. Let’s say you are in the 32% federal income tax bracket and 20% capital gains tax bracket. Your depreciation recapture would be taxed at a max of 25% totaling $31,818 ($127,270 x 25%). The amount subject to capital gains tax is $250,000 ($377,270 - $127,270). There are expenses that are deductible from this gain such as sales commission and closing costs. Assuming the sales commission is 3% ($30,000) and the closing costs are 2% ($20,000), you would deduct $50,000 from your initial gain of $250,000 for a taxable gain of $200,000. You would owe $40,000 ($200,000 x 20%) in capital gains tax for a total tax liability of $71,818.
Let’s say you elected to utilize a cost segregation study and bonus depreciation instead of using straight-line depreciation. You would likely owe more in taxes upon the sale of the property due to the accelerated depreciation. However, if you had not utilized cost segregation to decrease your taxable income and instead used straight-line depreciation, your taxable income over the past 5 years would’ve been significantly higher. This income would’ve been taxed at your ordinary tax rate of 32% rather than the Section 1250 depreciation recapture tax rate which is maxed at 25%. It’s important to note that the property reclassified to personal property as a result of the study is taxed at ordinary tax rates. However, you could still actually end up paying less in taxes over the five year time period.
So while you may have to pay more in taxes upon the sale of a property by utilizing cost segregation, you can see that you can actually save money on taxes. And on top of the tax savings, you paid in less money in taxes each year, increasing your cash flow and allowing you to pay down debt, invest and compound your money over time. Additionally, if you were to get an updated cost segregation study regularly, this would allow you to retire assets. Retired assets are not subject to depreciation recapture, thus enabling you to save even more on taxes.
This is a list of some ways to avoid recapture:
- Move into the property for at least two years before selling it making it your primary residence to eliminate capital gains tax
- 1031 Exchange: swap one investment property for another and defer capital gains taxes
- 721 Exchange: exchange appreciated real estate property held for business or investment purposes for units in an operating partnership that will be converted into shares of the real estate investment trust (REIT)
- Place the property in your estate and when it passes to your heirs, they do not inherit the deferred depreciation recapture or capital gains and instead inherit it at FMV
What are your thoughts or questions on depreciation recapture?
