Depreciation recapture: What it is and how cost segregation affects it

Cost segregation is a fantastic tax savings tool. But that doesn’t mean the IRS is going to let you maximize your depreciation tax savings upfront and then sell your property at a profit without taking a cut.

Depreciation recapture is the IRS’s way of getting some money back when you sell a property that you’ve taken depreciation expenses for at a profit.

In this article, we’ll go into detail on what it is, how cost segregation studies affect it, and how you can avoid it through a 1031 exchange.


What is depreciation recapture?


When you claim depreciation expenses over the life of your property, you could become subject to a future tax called ‘depreciation recapture’ when you sell the property. This tax stems from IRS policy that states individuals can’t claim depreciation for an asset and reduce their income tax burden, then sell that asset for a profit without paying back the IRS.


Let’s break this down further. The IRS allows you to depreciate your real estate investments over certain time periods (faster if you do a cost segregation study). The standard depreciation period for a commercial property is 37 years. Each year you take depreciation, your income tax burden is reduced by a certain amount. However, by taking depreciation, you are reducing your property’s depreciation-adjusted cost basis. If you sell the property, any gains from that sale will be subtracted from the lowered cost basis. What’s left over is the depreciation recapture, i.e. the profit that the IRS wants to tax you extra for.

Depreciation recapture is taxed as ordinary income, which can be much higher than capital gains taxes. So, if you sell an investment property for a profit after taking depreciation, you may get taxed at a higher rate because of depreciation recapture.


How does cost segregation affect depreciation recapture?


Depreciation recapture only happens when you sell your property. So, if you don’t plan on selling it, you won’t be affected. However, if you do sell a property within a few years of doing a cost segregation study, it can affect you more than if you hadn’t (but there are ways to avoid this, more to come later on).

When you do a cost segregation study, you push more of your depreciation tax savings into earlier years of the life of your property. Because you saved money on taxes from accelerated depreciation, you could be looking at increased taxes from depreciation recapture when you sell for a profit.

To put it simply, taking extra depreciation expenses through cost segregation can potentially increase your taxes when you sell. That’s thanks to depreciation recapture.


How to calculate depreciation recapture



Calculating depreciation recapture requires you to know three numbers: the sale price, the cost basis, and the depreciation-adjusted cost basis.


First, figure out your current cost basis, which is the price you paid for the property, along with any closing costs you paid. Then, calculate your adjusted cost basis by subtracting the deductions you’ve taken since you’ve owned the property (including depreciation) from the cost basis. Then, subtract the adjusted cost basis from the sale price. What’s left over is what you will owe depreciation recapture taxes on. See the equation below.


Sale price – Adjusted cost basis = Profits subject to depreciation recapture


Can you avoid depreciation recapture?


The best way for investment property owners to avoid paying depreciation recapture is through a 1031 exchange. This IRS tax code can stop you from paying depreciation recapture and capital gains tax. Under a 1031 exchange, you use the proceeds from selling your property to buy another like-kind property of equal or greater value.

This isn’t a great strategy if you’re looking to take profits. But if you’re looking to level up your investment properties, then using a 1031 exchange will save you a ton. For those seeking to simply flip a property and make some cash, there really isn’t a good way to get around depreciation recapture, so you’ll need to plan for it—whether you did a cost segregation study or not.


Is it still worth it to do a cost segregation study?



With depreciation recapture, the first thing you should consider is whether or not you plan to sell your property for a profit. If the point of your investment property is to perpetually earn profits through rent, rather than through selling, then depreciation capture isn’t an issue. Any tax savings you gain through cost segregation will not result in future tax increases later on.


If you’re planning to flip the property within the next 5 years or so, then you need to consider the net present value of the tax savings you’ll get over the next 5 years vs. the future recapture tax. There is no way that the recapture tax can be more than the savings you’ll get over 5 years, but you don’t want to get surprised with a large tax bill you can’t afford down the road. If you manage the tax savings wisely and put it into other money-making investments, then paying that extra tax down the road shouldn’t be an issue.

If you’re worried about it, this is something you should definitely discuss with your CPA.


Estimate your depreciation tax savings

If you’re curious about how much you could save on your income taxes by doing a cost segregation study, check out our free commercial property refund calculator.

About Author

Richard Bourgault

Graduating from Georgia Tech with a degree in Electrical Engineering, Richard has gained over a decade of expereince in Cost Segregation coupled with software UX.

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