Sections 1245 & 1250
Depreciation recapture, and what acceleration really costs on exit
Cost segregation is a timing strategy. Anyone who tells you it is free money has not modelled the sale. Here is the honest version.
Two regimes, two outcomes
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 the gain on that asset. Ordinary rates, up to 37% federal.
Section 1250 property — the building and 15-year land improvements — recaptures differently. Because these assets use straight line (or, for land improvements, a declining balance method), there is generally little or no additional section 1250 recapture. Instead, gain attributable to depreciation is unrecaptured section 1250 gain, taxed at a maximum federal rate of 25%.
Remaining gain above depreciation is long-term capital gain at 0, 15 or 20%, plus the 3.8% net investment income tax where applicable.
| Component | Section | On sale | Federal rate |
|---|---|---|---|
| 5 and 7-year personal property | 1245 | Ordinary recapture to extent of depreciation | Up to 37% |
| 15-year land improvements | 1250 | Unrecaptured 1250 gain | 25% max |
| Building (27.5 / 39-year) | 1250 | Unrecaptured 1250 gain | 25% max |
| Appreciation above basis | 1231 | Long-term capital gain | 0/15/20% + NIIT |
So is it worth it?
Usually, and here is the arithmetic. Suppose a study accelerates $400,000 of deductions from years two through thirty-nine into year one, at a 37% marginal rate. That is roughly $148,000 of tax deferred.
On a sale ten years later, the portion attributable to section 1245 property recaptures at ordinary rates — call it $200,000 of the $400,000, costing $74,000. You have had the use of $148,000 for a decade and paid back part of it. At any reasonable discount rate the net present value is comfortably positive.
The cases where it goes the other way are real but specific: a short hold with no ability to use the deduction in the year taken, or an owner whose marginal rate rises sharply between acquisition and sale.
— Death. Heirs generally take a stepped-up basis under section 1014, and the depreciation taken during life is not recaptured. Acceleration in an estate-planning context can be extremely efficient.
— 1031 exchange. Gain, including recapture, is generally deferred where the exchange is properly structured — though section 1245 property has its own like-kind matching requirements and the rules tightened after 2017. Coordinate the study with the exchange, not after it.
— Continued holding. Nothing recaptures until there is a disposition.
Planning points worth raising before the study, not after
- What is your expected hold period, honestly?
- Do you expect to exchange, sell outright, or hold to death?
- Will the deduction be usable in the year taken, or suspended under the passive activity rules?
- Are you likely to be in a higher bracket at sale than at acquisition?
- Does your state conform, and will you still be a resident of it when you sell?
We model the exit as part of every feasibility review. If the answer is that a study does not pay for you, we would rather say so on a twenty-minute call than after you have paid for one.
No-cost feasibility review
Find out what your building is hiding.
A feasibility review is free and takes about twenty minutes. Bring the closing statement and the depreciation schedule; we will tell you plainly whether a study pays for itself.