Cost Segregation and Depreciation Recapture: What to Expect
Cost segregation and depreciation recapture are directly linked. A cost segregation study accelerates depreciation by reclassifying building components into shorter asset lives. When a property with a completed study is sold, the accumulated depreciation on those reclassified components must be recognized as recapture income. Understanding this interaction is essential for making informed decisions about whether and when to commission a study.
This page explains how recapture after cost segregation works in practice, what a cost segregation short hold analysis looks like, and how to model break-even cost segregation before sale scenarios. The goal is to provide a clear framework for evaluating the full lifecycle economics of a study.
TL;DR -- Key Takeaway
How Recapture Follows a Study
When a cost segregation study reclassifies building components into 5-year, 7-year, or 15-year asset classes, those components are depreciated faster than the 27.5 or 39-year schedule for real property. This accelerated depreciation reduces taxable income in early years, which is the primary benefit investors seek.
On sale of the property, those same reclassified components carry an adjusted basis equal to their original cost less accumulated depreciation. If bonus depreciation was applied, the basis may be zero. The sale proceeds attributable to those components are subject to Section 1245 recapture at ordinary income rates. The recapture is not a penalty for doing the study. It is the mechanical reversal of the prior deductions.
The net recapture from the study equals the recapture on the study-allocated components minus what that same basis would have generated under standard 39-year depreciation. Investors who compare only the gross recapture without accounting for the baseline overstate the recapture cost and undervalue the study.
Cost Segregation Recapture Impact
The cost segregation recapture impact depends on several variables: the percentage of depreciable basis reclassified, the applicable bonus depreciation rate, the hold period, and the taxpayer's effective ordinary income rate at exit. A property with a large portion of eligible personal property and a short hold period will have a higher incremental recapture impact than one with modest eligible components held for a decade.
The recapture impact from cost seg and recapture is not symmetric with the initial benefit. If the study generates a $200,000 first-year deduction that saves $74,000 in tax at a 37% rate, but the eventual recapture on those components costs $55,000 in tax at a lower blended rate, the net benefit is $19,000 on the tax savings alone, before accounting for time value. In most long-hold scenarios, the time value of money makes the early deduction more valuable than the deferred recapture cost.
Table 1: Factors That Increase or Decrease Recapture Impact
| Factor | Effect on Recapture | Planning Note |
|---|---|---|
| Higher percentage of 5/7-year components | Increases Section 1245 recapture | More upfront benefit, more ordinary income at exit |
| 100% bonus depreciation applied | Maximizes recapture exposure | All basis at zero; full proceeds are recapture |
| Long hold period (10+ years) | Time value reduces net recapture cost | Early savings compound; recapture is distant |
| Lower marginal rate at exit | Reduces recapture cost | Rate arbitrage improves overall economics |
| 1031 exchange on sale | Defers recapture recognition | Recapture carries to replacement property basis |
Cost Segregation Short Hold Analysis
A cost segregation short hold analysis evaluates whether the economics of a study are favorable when the property will be sold within a few years. This matters because the primary benefit of cost segregation is the time value of deductions taken early. If the hold period is short, there is less time for that value to accumulate.
The analysis compares two scenarios: owning the property with the study and owning it without. For each scenario, the analysis models annual after-tax cash flows (with and without the accelerated depreciation), the tax on sale (with and without the higher recapture from the study), and the net present value of the total difference.
Inputs for a short hold analysis
- Depreciable basis and expected allocation between 5, 15, and 39-year assets
- Applicable bonus depreciation rate for the placed-in-service year
- Effective ordinary income rate and long-term capital gain rate
- Cost of the study
- Expected sale price and timing
- Discount rate for present value calculation
For a short hold of two to three years, the study may still be favorable depending on the size of the eligible basis and the investor's tax rate. For properties with a modest eligible component percentage or low effective tax rates, the break-even may extend beyond the anticipated sale date.
Break-Even Cost Segregation Before Sale
Break-even cost segregation before sale refers to the minimum time needed for the tax savings from a study to offset the study cost and any incremental recapture on early exit. It is a specific form of break-even analysis focused on the exit scenario.
At the break-even point, the present value of the after-tax benefit from the accelerated deductions equals the present value of the incremental recapture plus the study fee. Below this threshold, the study costs more than it saves. Above it, the investor is ahead on an after-tax, risk-adjusted basis.
The recapture tax rate on personal property components (ordinary income) is typically higher than the rate on Section 1231 gains, which makes the break-even more sensitive to the proportion of basis in short-life classes. Properties with less than 15% of eligible components in 5 and 7-year classes may have break-even periods that are too long to justify a study before an imminent sale.
Recapture by Component Class
Different component classes generate different types of recapture. Understanding this split helps investors model exit taxes more precisely and avoids conflating the overall tax rate on sale.
- 5-year and 7-year personal property: Fully subject to Section 1245 recapture at ordinary income rates on the accumulated depreciation.
- 15-year land improvements: Also Section 1245 property; depreciation is recaptured at ordinary income rates.
- 27.5-year or 39-year real property: Generates unrecaptured Section 1250 gain at a maximum 25% rate. This applies regardless of whether a cost segregation study was done, since the building shell depreciates at straight-line.
After a cost segregation study, the total recapture pool is larger because more basis has been depreciated at accelerated rates. The recapture is split between Section 1245 (ordinary rates) on the reclassified components and unrecaptured Section 1250 (25% maximum) on the building remainder.
Planning Around Recapture
Investors can use several strategies to manage the recapture impact from a cost segregation study. None of these strategies eliminate recapture permanently, but they can defer, shift, or reduce its effective cost.
- 1031 exchange: Defers all gain recognition, including recapture, by rolling into a replacement property. The deferred recapture attaches to the replacement property's basis.
- Installment sale: Spreads gain recognition over multiple years. Section 1245 recapture is recognized in the year of sale regardless of payment schedule under most structures, so this tool has limited effectiveness for ordinary income recapture.
- Hold period extension: Longer holds reduce the effective annual cost of recapture by giving the early deductions more time to generate compounding reinvestment value.
- Death and estate planning: Heirs receive a stepped-up basis at death, which can eliminate accumulated depreciation and recapture entirely in some situations.
For a comprehensive review of minimizing recapture exposure through specific strategies, see the dedicated guide. You can also review the overview of all depreciation recapture concepts in the pillar guide.
Frequently Asked Questions
How does cost segregation and depreciation recapture interact?
Cost segregation increases accumulated depreciation by reclassifying components into shorter asset classes. When the property sells, that additional depreciation becomes additional recapture exposure. The trade-off is earlier tax savings versus higher recapture at exit. Whether the net outcome is favorable depends on hold period, reinvestment rate, and marginal tax rates at sale.
Is the recapture after cost segregation automatic?
Recapture is triggered on sale or disposition of a depreciable asset at a gain. It is not automatic in the sense that it only applies when there is a taxable disposition. A 1031 exchange, installment sale structure, or estate step-up can defer or eliminate recapture under specific circumstances.
What is a cost segregation short hold analysis?
A cost segregation short hold analysis models whether the accelerated deductions provide enough present-value benefit to outweigh the recapture tax at an early exit date. The analysis typically includes the study fee, the tax savings from accelerated depreciation, the incremental recapture on sale compared to a no-study baseline, and the net present value of the difference.
At what hold period does cost segregation typically break even?
The break-even point varies by property type, tax rate, and bonus depreciation eligibility. For properties with substantial 5-year and 15-year component bases and high effective tax rates, break-even can occur within two to three years. For properties with modest eligible components or lower tax rates, the break-even may extend to five or more years. Your CPA should run property-specific numbers.
Does cost seg and recapture affect my 1031 exchange planning?
Yes. In a 1031 exchange, accumulated depreciation transfers to the replacement property's basis. The recapture is deferred, not eliminated. If you eventually sell the replacement property outside of another exchange, the deferred recapture on both the original and replacement property will be recognized. This stacked recapture should be modeled in long-term exchange chain planning.
Does recapture after cost segregation apply to bonus-depreciated components?
Yes. If components were fully depreciated in Year 1 through bonus depreciation, the adjusted basis is zero. On sale at a gain, the full proceeds attributable to those components are subject to Section 1245 recapture at ordinary rates. The higher the bonus depreciation taken, the more recapture is possible on a short-hold disposition.
How does cost segregation recapture impact differ between holding and selling?
While holding, there is no recapture. The benefit is the early deduction reducing current taxable income. On sale, recapture converts some of the accumulated depreciation back to ordinary income. Longer hold periods generally allow more of the time-value benefit to accumulate before recapture is triggered.
Can I estimate recapture exposure before doing a cost segregation study?
Yes, a preliminary estimate can be built from the property's depreciable basis, the expected percentage eligible for reclassification by asset class, projected hold period, and assumed tax rates. A qualified cost segregation firm or tax advisor can provide a pre-study pro-forma that includes the recapture impact at various exit scenarios.
Next: Understand how the specific depreciation recapture tax rate is applied across different asset classes under the 25% rule.