Depreciation Recapture: Paying the Piper When a Depreciated Property is Sold

This is a guest post by John Hanning, MBA, CCSP – Principal, Specialty Tax Group

Cost Segregation Can Help Minimize Recapture Tax

When a property owner sells an asset that previously was used to offset ordinary income through depreciation, the gain is taxed through depreciation recapture.

The process of depreciation recapture closes a tax loophole that allowed taxpayers to take depreciation deductions against ordinary income while the subsequent sale of those assets was taxed at lower capital gain rates. Because a taxpayer is permitted to deduct the depreciation of an asset from ordinary income, they must report any gain from the disposal of the asset (up to the recomputed basis) as ordinary income, not as a capital gain. Therefore, through depreciation recapture, a portion of the gain may be taxed at ordinary income rates as high as 25% for real property and 39.6% for personal property. Any gain over the recomputed basis will be taxed as a capital gain.

Depreciation recapture most commonly applies when dealing with the sale of improved real estate (such as rental property), as the value of real estate generally increases over time while the improvements are subject to depreciation. Depreciation recapture is governed by sections 1245 and 1250 of the Internal Revenue Code (IRC).

Knowledgeable taxpayers realize that depreciation recapture is not always a bad thing, since – in certain circumstances – the net present value of the tax savings realized through depreciation is greater than the recapture tax. So, the recapture does not entirely cancel out the benefit the taxpayer has realized during the depreciation period.

Impact of Cost Segregation

Cost segregation can magnify recapture tax liability, but there are strategies to mitigate the impact. When an asset has been subject to front-loaded depreciation and is sold, the IRS may determine that too much depreciation has been taken. In such a case, we recalculate the depreciation amount that would have been taken under the straight-line method, and the delta is what is taxed at ordinary income tax rates, not the lower capital gain rate.

Moreover, when you have a cost segregation study done, all the assets are separately stated as real property assets or personal property assets. This allows a taxpayer to make sure the recapture tax is calculated appropriately. In many cases, the benefits of the study will offset any cost to the taxpayer.

For a cost segregation study, we break out assets for identification of allowable dispositions. A building never looks the same tomorrow as it does today. There are constant improvements and renovations. If the owner has basis in certain assets that are there today, but not when they sell, they can take the allowable disposition in the year it occurs and take an immediate deduction. But when they sell and those assets are no longer in the building, there’s no recapture on it.

The primary goal of a cost segregation study is to drive down current income. But a secondary goal is to create documentation that explains what the assets cost, so down the line the owner can take allowable dispositions.

Impact of a 1031 Exchange

When a property owner disposes of investment property through a 1031 like-kind exchange, generally no gain or loss is recognized at the time of the exchange. So, in the immediate sense the taxpayer can avoid some of the tax impact of a recapture. Ultimately, this just kicks it down the road since the recapture will be applied when the property is ultimately sold. But in certain circumstances, particularly if a taxpayer doesn’t need the immediate gain from selling the property and is interested in owning a subsequent property, a 1031 exchange is something to consider.

If you would like to have a conversation about the potential tax impact of selling your investment property, contact John at John.Hanning@SpecialtyTaxGroup.com or 614.923.6545.

By: John Hanning, MBA, CCSP (Specialty Tax Group)