What Happens to Cost Segregation When You Sell?
When you sell a property after completing a cost segregation study, depreciation recapture applies to the accelerated deductions you claimed. The recapture is taxed as ordinary income, which can reduce the net benefit of the cost segregation strategy.
Understanding cost segregation when sell scenarios is critical for long term planning. The tax impact of selling a cost segregated property depends on holding period, sale price, tax rates, and whether you use strategies like 1031 exchanges to defer recapture.
TL;DR – Key Takeaway
What Happens When You Sell
When you sell a property with cost segregation, the IRS requires you to recapture the depreciation deductions you claimed. Recapture means that the accelerated depreciation is taxed as ordinary income up to the amount of depreciation taken, rather than being taxed at capital gains rates.
Cost segregation when sell scenarios are more complex than selling a property with standard depreciation because more depreciation was claimed earlier. The recapture amount can be higher, which increases the tax due on sale. However, the time value of money from the earlier deductions can still produce a net benefit.
The sale triggers recapture calculations based on the depreciation schedules. Your CPA will compare the adjusted basis of the property to the sale price and allocate recapture between ordinary income and capital gains. The cost segregation component breakdowns affect this calculation.
Depreciation Recapture Basics
Depreciation recapture applies to all depreciation, not just cost segregation. When you sell depreciable property, the IRS taxes the gain attributable to depreciation deductions as ordinary income up to the total depreciation claimed. This is called recapture.
For real property, recapture under Section 1250 applies to the portion of gain attributable to depreciation. For personal property and certain land improvements reclassified through cost segregation, recapture under Section 1245 may apply, which also recaptures at ordinary income rates.
The recapture amount is limited to the gain realized. If you sell at a loss or break even, there is no recapture. If you sell at a gain less than the total depreciation claimed, the recapture is limited to the gain. If the gain exceeds depreciation, the excess is typically long term capital gain.
Table 1: Depreciation Type vs Recapture Section vs Tax Rate
| Depreciation Type | Recapture Section | Tax Rate |
|---|---|---|
| Building depreciation (27.5 or 39 years) | Section 1250 | Ordinary income up to depreciation claimed |
| Personal property (5 or 7 years) | Section 1245 | Ordinary income up to depreciation claimed |
| Land improvements (15 years) | Section 1250 or 1245 | Ordinary income up to depreciation claimed |
| Gain above depreciation | Capital gain | Long term capital gains rate if held over 1 year |
Cost Segregation Sale Impact
Cost segregation sale impact is the additional recapture tax compared to standard depreciation. Because cost segregation accelerates deductions, more depreciation is claimed earlier, which means more recapture when you sell. This reduces the net benefit of the strategy.
The impact depends on how much depreciation was accelerated, the holding period, and the sale price. If you hold the property long enough, the time value of the earlier deductions can exceed the recapture cost. If you sell quickly, the recapture can offset much of the benefit.
Sell property after cost seg scenarios should be modeled before implementing the study. Your CPA can estimate the recapture cost based on different sale timelines and prices, helping you understand whether the net benefit justifies the study cost.
Table 2: Holding Period vs Recapture Impact vs Net Benefit Outlook
| Holding Period | Recapture Impact | Net Benefit Outlook |
|---|---|---|
| Under 3 years | High, limited time value benefit | May be negative or minimal |
| 3 to 5 years | Moderate, some time value benefit | Neutral to positive depending on rates |
| 5 to 10 years | Moderate, time value benefit increasing | Positive in most scenarios |
| Over 10 years | Lower relative impact, strong time value | Strongly positive |
| 1031 exchange (deferred) | Recapture deferred to future sale | Benefit preserved until final sale |
Holding Period and Recapture
Holding period is one of the most important factors in cost segregation and property sale planning. Longer holding periods allow the time value of earlier deductions to compound, which can offset the recapture cost on sale.
If you plan to sell within a few years, the recapture cost may be high relative to the benefit. The earlier tax savings will not have time to be reinvested or to compound. In contrast, if you hold for ten or more years, the time value benefit can far exceed the recapture cost.
When evaluating selling cost segregated property scenarios, discount future recapture taxes to present value and compare them to the present value of tax savings. This time value analysis is essential for understanding the true economic benefit.
1031 Exchanges and Cost Segregation
A 1031 exchange allows you to defer recapture by exchanging the property for like kind replacement property. The depreciation recapture is not eliminated but deferred until you sell the replacement property in a taxable sale.
Cost segregation does not prevent 1031 exchanges. You can exchange a cost segregated property and carry over the depreciation schedules with adjustments to the replacement property basis. The deferred recapture will eventually be recognized when you sell without exchanging.
Using 1031 exchanges as part of a cost seg exit strategy allows you to preserve the benefit of earlier deductions while deferring the recapture. This can extend the time value benefit indefinitely if you continue to exchange.
Cost Seg Exit Strategies
Cost seg exit strategies help you maximize the benefit of cost segregation even when planning to sell. These strategies involve timing, tax planning, and reinvestment decisions that can reduce the recapture impact or enhance the overall return.
Common exit strategies
- 1031 exchange: Defer recapture by exchanging into replacement property and continue the depreciation benefit.
- Longer hold period: Hold the property longer to increase the time value benefit relative to recapture cost.
- Installment sale: Spread the gain over multiple years, which can smooth recapture tax and manage cash flow.
- Charitable remainder trust: Donate the property to a CRT to defer or eliminate capital gains and recapture, subject to complex rules.
- Model before implementing: Estimate recapture cost before doing the study to ensure the net benefit is positive.
Each strategy has trade offs and requires professional guidance. Work with your CPA and advisors to choose the approach that fits your investment goals and tax situation.
Modeling Recapture Before Implementing
Before implementing cost segregation, model the recapture cost under different exit scenarios. This helps you understand whether the strategy makes sense given your expected holding period and exit plan.
A typical model includes assumptions for sale price, holding period, tax rates, and reinvestment return. By comparing the present value of tax savings to the present value of recapture cost, you can estimate the net benefit. Sensitivity analysis on different holding periods helps identify break even points.
If the model shows negative net benefit for your expected holding period, cost segregation may not be appropriate. If the model shows strong positive benefit even after recapture, the study is likely worthwhile. This analysis should be part of the decision process, not an afterthought.
When Cost Segregation Still Makes Sense
Cost segregation can still make sense even when you plan to sell, especially if the holding period is long enough or if you plan to use a 1031 exchange. The key is ensuring the time value of earlier deductions exceeds the recapture cost.
When cost segregation remains beneficial despite sale
- Holding period of five years or more, allowing time for reinvestment and compounding.
- Plan to use 1031 exchange to defer recapture and continue the benefit.
- High marginal tax rate and strong reinvestment opportunities that amplify the time value benefit.
- Property characteristics that produce very high eligible component percentages, increasing the absolute benefit.
- Tax planning that coordinates sale timing with other income or deductions to manage recapture impact.
Even with recapture, the net benefit can be substantial. The misconception that cost segregation only works for long term holds is incorrect. It works best for long term holds, but it can still be beneficial for medium term holds when modeled correctly.
Frequently Asked Questions
What happens to cost segregation when you sell the property?
When you sell, depreciation recapture applies to the accelerated deductions taken through cost segregation. The amount recaptured is taxed as ordinary income up to the depreciation claimed, which can reduce the net benefit of the strategy.
Does cost segregation increase taxes when you sell?
Cost segregation can increase recapture taxes on sale because more depreciation was taken earlier. However, the overall tax impact depends on holding period, tax rates, sale price, and the time value of money from earlier deductions.
Can you avoid recapture when selling a cost segregated property?
Recapture is generally unavoidable on sale, but strategies like 1031 exchanges can defer it. The recapture rules apply to the depreciation taken, not to the cost segregation strategy itself.
How does cost segregation affect 1031 exchanges?
Cost segregation does not prevent 1031 exchanges. If you exchange into like kind property, recapture is deferred. The depreciation schedules carry over to the replacement property with adjustments.
What is the cost seg exit strategy if I plan to sell soon?
If you plan to sell within a few years, cost segregation may still be beneficial if the present value of tax savings exceeds the recapture cost. Model the scenario with your CPA before deciding.
Does selling cost segregated property always result in higher taxes?
Not always. The net tax impact depends on sale price, holding period, and whether the property appreciated. If you hold long enough and tax rates are favorable, the time value benefit can exceed recapture cost.
Can I reverse cost segregation before selling to avoid recapture?
No, you cannot reverse cost segregation to avoid recapture. Once depreciation is taken, it is factored into basis and recapture calculations. Reversing the study does not undo the deductions.
How does cost segregation sale impact differ by property type?
The recapture rules are the same across property types, but the impact depends on how much depreciation was accelerated and the sale price. Properties with higher reclassification percentages may face more recapture.