Depreciation recapture: the part of the pitch that usually gets skipped

Two regimes

Section 1245 property — the 5 and 7-year personal property a study identifies — recaptures as ordinary income to the extent of depreciation taken, limited to gain on that asset. Ordinary rates up to 37% federal.

Section 1250 property — the building and 15-year land improvements — uses straight line or a declining balance method that produces little or no additional section 1250 recapture. Instead, gain attributable to depreciation is unrecaptured section 1250 gain, capped at 25% federal.

Gain above depreciation is long-term capital gain at 0, 15 or 20%, plus 3.8% net investment income tax where it applies.

Does it still pay?

Usually. Suppose a study accelerates $400,000 of deductions into year one at a 37% rate — roughly $148,000 of tax deferred.

On a sale ten years later, say $200,000 of that was section 1245 property recapturing at ordinary rates, costing $74,000. You have had the use of $148,000 for a decade and repaid part of it. At any reasonable discount rate the net present value is comfortably positive.

When it does not

Short holds where the deduction is recaptured almost immediately at a similar rate. Owners whose marginal rate rises sharply between acquisition and sale. Owners who could not use the deduction in the year taken, so the deferral benefit never materialised while the recapture still does.

Three exits where recapture largely disappears

Death. Heirs generally take a stepped-up basis under section 1014 and depreciation taken during life is not recaptured. Acceleration in an estate planning context can be very efficient.

1031 exchange. Gain including recapture is generally deferred where the exchange is properly structured, though section 1245 property has its own matching requirements. Coordinate the study with the exchange rather than after it.

Continuing to hold. Nothing recaptures without a disposition.

Model it first

Hold period, expected rates at sale, exit route, usability of the deduction in the year taken, and state conformity. We run this on every feasibility review, because the answer occasionally is that a study does not pay — and that is worth knowing before the fee, not after.