Cost Segregation Before Selling a Property

Cost segregation before selling can make sense in specific circumstances, but it requires careful analysis. Unlike the acquisition scenario, where there are many years ahead to benefit from accelerated depreciation, cost segregation prior to sale compresses the benefit window to the remaining time before closing.

The key economic question is whether the present-value tax savings from the accelerated deductions in the pre-sale period exceed the study cost plus the incremental recapture that will be recognized at closing. If the answer is yes, the study provides a net benefit even in the context of a near-term sale.

Properties that have never been studied and that still have substantial eligible components (typically commercial properties with significant personal property and land improvements) are the strongest candidates. Properties that were already studied and fully depreciated on eligible classes have no remaining basis to reclassify and would not benefit from a new study.

The timing between the cost segregation study and the sale closing is the most important variable in evaluating cost seg then sell scenarios. The earlier the study is completed before closing, the more tax benefit can be captured.

• Study and sale in the same tax year: The accelerated depreciation and the recapture offset in the same year. The net benefit is typically the difference in rate (if ordinary rate exceeds the long-term rate on some gain components), minus the study fee.
• Study in the year before the sale: The deduction is taken in Year N, providing a tax refund or liability reduction. The recapture is triggered in Year N+1. This one-year gap allows the investor to hold and invest the tax savings for a year before the recapture comes due.
• Study two or more years before the sale: The benefit grows with each additional year of cash flow advantage before the recapture is triggered.

For a sale scheduled within three to six months, the same-year scenario applies. For a sale planned one to two years out, the analysis becomes more favorable.

A proper cost segregation prior to sale analysis includes the following components:

• Eligible basis: What portion of the depreciable basis has not yet been reclassified into short-life asset classes? This determines the maximum additional depreciation available.
• Applicable bonus depreciation rate: If bonus depreciation applies in the current year, the eligible components may be deducted entirely in the year of study. This increases the Year 1 benefit but also increases recapture exposure.
• Tax rate at deduction: What is the owner's marginal ordinary income rate? Higher rates mean larger dollar savings from the deduction.
• Tax rate at recapture: What ordinary income rate will apply at exit? If the rate is expected to be lower (due to retirement, for example), the rate arbitrage adds to the net benefit.
• Study cost: The fee for the cost segregation study reduces the net benefit and must be recovered through the tax savings.

In this simplified example, the study essentially funds a one-year deferral of $59,200 in tax for a cost of $8,000. Whether that deferral is valuable depends on what the investor does with the cash during that year. If the investor can earn a return on the deferred tax, the deferral has positive value even at the same rate.

A lookback study allows investors who have owned a property for multiple years to claim depreciation missed in prior years through a current-year deduction via a Section 481(a) adjustment on Form 3115. This can be a significant amount for long-held properties.

Before a sale, a lookback study can produce a large current-year deduction that offsets income in the year the Form 3115 is filed. However, all the depreciation captured in the 481(a) adjustment also becomes recapture exposure on the sale, which closes in the same or following year.

The timing is critical. If the 481(a) adjustment creates a large deduction in Year N and the sale closes in Year N+1, the investor benefits from a year of tax savings before the recapture comes due. If the sale closes in Year N as well, the benefit is compressed into the same tax period.

The sale of a property with accumulated depreciation triggers recapture in the year of closing. The amount recaptured depends on the accumulated depreciation on each asset class: Section 1245 components (personal property and land improvements) generate ordinary income recapture, while the building's straight-line depreciation generates unrecaptured Section 1250 gain at a maximum 25% rate.

A cost segregation study increases the Section 1245 recapture component because it moves basis into personal property classes that are fully subject to ordinary-rate recapture. Without the study, most of the accumulated depreciation would be building depreciation generating the 25% unrecaptured Section 1250 gain. The difference in rate (ordinary versus 25%) is the recapture rate cost of the study on a per-dollar basis.

Cost segregation before selling makes economic sense in the following scenarios:

• The property has substantial eligible personal property and land improvements that have not been studied, leaving significant basis available for reclassification.
• The owner's ordinary income tax rate at the time of the study is higher than the expected rate at sale (creating rate arbitrage in favor of the early deduction).
• The sale is at least one full tax year away, allowing the deduction to reduce a full year of tax liability before recapture is triggered.
• The investor plans a 1031 exchange on the replacement property, meaning the recapture on the current sale is itself being deferred.
• The property will be exchanged in a 1031 and the study establishes detailed component records that simplify the replacement property's depreciation setup.

For property owners in the specific situation of an imminent sale, the more detailed analysis of whether cost segregation makes sense if you are selling soon addresses the edge cases and decision framework for very short hold periods.

Cost segregation before selling does not make economic sense in these situations:

• The property has already been fully studied and eligible components are already in short-life classes with no remaining basis to reclassify.
• The sale will close within weeks and the owner's tax rate at deduction equals the rate at recapture, leaving no rate arbitrage and a net negative outcome after the study fee.
• The property has very few eligible components (for example, a plain-shell warehouse with no specialized systems or site improvements), making the eligible reclassifiable basis too small to justify the study cost.
• The owner has no taxable income to offset and cannot use the deduction in the current year, with no carryback or carryforward benefit anticipated before the property closes.

For context on the full depreciation recapture framework and how it applies to property dispositions, see the pillar guide. The strategy for what to expect from recapture after a cost segregation study provides additional context on the full economics.