Does Cost Segregation Make Sense If I'm Selling Soon?
Investors preparing to sell a property in the near term often ask whether commissioning a cost segregation study is still worthwhile. The concern is reasonable: cost segregation accelerates depreciation deductions, but selling the property soon after means those deductions will be recaptured as ordinary income at closing. Whether the economics favor proceeding depends on how soon the sale is, the size of the eligible basis, and the tax rates at both the deduction and recapture stages.
This guide provides a structured framework for evaluating cost segregation if selling soon, including analysis of short hold periods, specific scenarios where the economics work, and the break-even thresholds investors should model before making a decision. For background on cost segregation and its interaction with depreciation on sale, see the main guide.
TL;DR -- Key Takeaway
The Cost Segregation Short Hold Problem
The short hold problem in cost segregation arises because the primary economic benefit of a study is the time value of early depreciation deductions. When a property is sold shortly after a study, the time for those early deductions to compound at after-tax rates is short, and the recapture at sale arrives before much compounding has occurred.
A cost segregation short hold creates a situation where the investor pays the study cost, generates an accelerated deduction, and then recognizes the recapture within months. At the same ordinary income tax rate, the deduction and the recapture are mirror images, and the only net cost is the study fee. But the fee can range from a few thousand to tens of thousands of dollars depending on the property's complexity.
The short hold is more problematic when the reclassified components consist largely of personal property subject to full Section 1245 recapture at ordinary income rates. It is less problematic when the expected ordinary income rate at exit is lower than at deduction, or when the investor plans a 1031 exchange.
When Cost Segregation If Selling Soon Still Works
Despite the compressed benefit window, cost segregation if selling soon can still produce a positive outcome under the following conditions:
- Rate arbitrage: If the marginal rate at the deduction year is significantly higher than the expected rate at exit (for example, the owner retires or has unusually high income in the current year), the dollar value of the deduction exceeds the dollar cost of the recapture.
- 1031 exchange at exit: The recapture is deferred into the replacement property, making the short hold objection moot. The study generates the accelerated deduction without triggering recapture in the near term.
- Suspended passive losses: If the investor has accumulated suspended passive activity losses that will be released at the fully taxable disposition, those losses offset the recapture income, reducing the net tax cost.
- Large eligible basis: When the eligible basis is very large, even a short deferral of the recapture tax generates an absolute dollar benefit that can exceed the study fee.
Break-Even by Hold Period
Table 1: Indicative Break-Even Analysis by Hold Period
| Remaining Hold | Likely Favorable? | Key Conditions |
|---|---|---|
| Less than 6 months | Rarely | Only if large eligible basis and significant rate arbitrage |
| 6 to 12 months | Situational | Requires rate advantage or large passive loss offset |
| 1 to 2 years | Often favorable | One-year deferral at high marginal rates typically positive |
| 2 to 5 years | Generally favorable | Time value works in investor's favor; recapture deferred longer |
| 5+ years | Favorable in most cases | Standard cost segregation economics apply |
These are general guidelines and not a substitute for a property-specific analysis. The eligible component percentage, bonus depreciation availability, study cost, and effective tax rates all affect the actual break-even. The table is meant to orient the analysis, not replace it.
The Two-Year Hold Analysis
A cost segregation 2 year hold analysis is a common scenario to evaluate. Many investors who are 18 to 24 months from a planned sale encounter this question and want a framework for deciding.
In a two-year hold, the investor can file a cost segregation study in Year 1 and claim the accelerated depreciation deductions (including any applicable bonus depreciation) in Year 1. The sale closes in Year 2, triggering the recapture. The benefit is one full year of deferral plus the compounding of the deferred tax amount at the investor's after-tax return rate.
Illustrative two-year example
- Eligible basis reclassified: $300,000
- Bonus depreciation rate: 60% (Year 1 deduction: $180,000)
- Tax savings at 37%: $66,600 received in Year 1
- Investor earns 8% after-tax on reinvested cash for one year: $5,328
- Study cost: $9,000
- Recapture in Year 2 at 37% rate: $66,600
- Net benefit: $5,328 earnings minus $9,000 study cost = ($3,672)
In this example at identical rates and an 8% reinvestment return, the study barely misses break-even on a two-year hold. At a higher reinvestment return or a lower rate at exit, the outcome shifts positive. At 12% reinvestment return, the deferral value is $7,992 versus the $9,000 study cost, still close. The numbers become more favorable when the study generates a larger initial deduction relative to its cost.
Passive Loss Offset on Sale
Investors who have accumulated suspended passive activity losses from prior cost segregation deductions receive those losses as ordinary deductions in the year of a fully taxable sale. This can substantially reduce the recapture tax.
If an investor has $100,000 of suspended passive losses from a cost segregation study and sells the property with $150,000 of recapture income, the passive losses offset $100,000 of the recapture, leaving only $50,000 net recapture income. This interplay means short-hold investors who were limited in using prior deductions due to passive activity rules may find that the deferred losses and the recapture partially cancel on sale.
Understanding the recapture tax rates and how passive losses interact with them is an important part of the short-hold analysis. Many investors with passive limitations discover they have a more favorable net tax position on sale than they anticipated.
1031 Exchange and the Short Hold
The most effective way to address the short hold objection to cost segregation is to plan a 1031 exchange at exit. When the sale proceeds roll into a qualifying replacement property in a valid like-kind exchange, no gain is recognized and no recapture is triggered in the sale year. The deferred recapture follows the adjusted basis into the replacement property.
From a cost segregation perspective, the short hold then becomes largely irrelevant. The investor takes the accelerated deductions in the study year, uses a 1031 exchange to avoid current recognition of recapture, and commissions a new study on the replacement property to restart the cycle. Over a portfolio of multiple exchanges, this strategy can defer substantial amounts of recapture indefinitely.
The complete overview of depreciation recapture explains how deferred recapture carries through exchanges and what happens when the chain eventually ends.
Decision Framework
Use the following framework to evaluate whether cost segregation makes sense given a short anticipated hold period:
Table 2: Decision Criteria for Cost Segregation on a Short Hold
| Criterion | Favors Study | Against Study |
|---|---|---|
| Eligible basis percentage | High (20%+ of depreciable basis) | Low (under 10%) |
| Tax rate at deduction vs exit | Rate higher now than at exit | Same or lower rate now |
| Exit strategy | 1031 exchange planned | Straight sale, no exchange |
| Suspended passive losses | Large accumulated balance | None or minimal |
| Time to sale | 12+ months | Less than 6 months |
| Study cost relative to benefit | Fee is small relative to eligible basis | Fee is large relative to eligible deduction |
Frequently Asked Questions
Does cost segregation make sense if I am selling in one year?
It depends on the eligible basis, tax rates, and whether a 1031 exchange is planned. In a same-rate scenario with no exchange, the study essentially costs the fee in exchange for a one-year deferral of the recapture tax. If the marginal rate at acquisition is higher than at exit, or if the proceeds can be reinvested productively during the deferral window, the study can still be positive. Run the specific numbers with your CPA.
What is a cost segregation short hold?
A cost segregation short hold is an ownership scenario where a property is sold within a few years of acquisition or study completion. Short holds typically present less favorable economics for cost segregation because there is limited time for the early deductions to compound before recapture is triggered. The threshold for what constitutes a short hold varies by property type, eligible basis, and tax rates.
What is the minimum hold period for cost segregation to make sense?
There is no universal minimum. The break-even hold period depends on the percentage of eligible basis, the bonus depreciation rate, the marginal tax rate, and the discount rate used for present value analysis. For properties with substantial eligible components (20 to 30% in 5 and 15-year classes) and high marginal rates, a two-year hold can still be favorable. For properties with modest eligible components, the hold period may need to be five or more years.
What is a cost segregation 2 year hold analysis?
A two-year hold analysis models the net present value of doing a cost segregation study on a property that will be sold in Year 2. The model includes the Year 1 deduction benefit, the study cost, the Year 2 recapture tax, and the time value of the one-year deferral. For most commercial properties with significant eligible components, a two-year hold analysis is often positive at high marginal rates.
Does a quick flip affect cost segregation strategy?
A quick flip (sale within 12 months of purchase or study) is generally not a favorable scenario for cost segregation. Short-term holding periods are also relevant because short-term capital gain and Section 1245 recapture are both taxed at ordinary rates, which reduces the gain character benefit on the appreciation component as well. Properties held less than one year do not benefit from long-term capital gain rates on any portion of the gain.
How does the cost segregation hold period affect the break-even?
Longer hold periods improve break-even in two ways: the early deductions have more time to compound at after-tax investment returns, and the present value of the future recapture obligation declines. The break-even analysis becomes more favorable with each additional year of hold. At very short holds (under one year), cost segregation is rarely cost-effective after accounting for recapture.
Can I do cost segregation if selling soon to benefit a buyer?
The cost segregation study belongs to the seller and is based on the seller's depreciation records. A buyer receives the property at its purchase price as a new tax basis and typically commissions a new study. The seller cannot transfer the benefit of the study to the buyer in a standard sale. However, detailed component records from the study can inform due diligence and property condition documentation.
What happens to unused passive losses from cost segregation if I sell?
Suspended passive activity losses from prior cost segregation deductions are released on a fully taxable disposition of the property. They become ordinary deductions in the year of sale, which can offset the recapture income. This is one reason why investors with large suspended passive losses may benefit from cost segregation even on a shorter hold: the losses may offset much of the recapture triggered at sale.
For a broader framework on minimizing the tax impact at exit, review the guide on how to minimize depreciation recapture tax. The full depreciation recapture guide provides the foundational rules and rate structure.