Cost Segregation and Depreciation Recapture at Sale

Two types of recapture from cost seg

A standard rental sale only has Section 1250 recapture (capped at 25%). A cost segregation study reclassifies some components as personal property (Section 1245). When you sell, the Section 1245 recapture on those components is taxed at ordinary income rates with no 25% cap, in addition to the Section 1250 recapture on the remaining real property.

How the numbers stack

Example: $40,000 in Section 1250 recapture plus $20,000 in Section 1245 recapture from cost-seg'd components. The $40,000 is capped at 25% = $10,000. The $20,000 at a 32% ordinary rate = $6,400. Without cost seg, all $60,000 might have been Section 1250 at 25% = $15,000. The difference is $1,400 — not large, but it illustrates the rate premium on Section 1245 components.

Still worth it for most investors

Despite the higher eventual recapture rate on 1245 components, the time value of taking large deductions years earlier usually outweighs the rate difference. A 1031 exchange can defer both types of recapture indefinitely. Use the cost segregation calculator to model whether early deductions justify the trade-off.

Which components are 1245 and which are 1250

A cost segregation study typically splits a building into three depreciation buckets, and they do not all recapture the same way. 5- and 7-year tangible personal property (appliances, carpeting, cabinetry, decorative lighting, dedicated electrical) is Section 1245 property — all depreciation claimed on it recaptures as ordinary income, with no 25% cap. 15-year land improvements (paving, sidewalks, fencing, landscaping, site lighting) are actually Section 1250 real property, not 1245. Because land improvements are depreciated straight-line, there is no additional depreciation to recapture at ordinary rates, so their gain is unrecaptured Section 1250 gain taxed at up to 25% — not the ordinary-rate treatment. Only the personal-property portion carries the ordinary-income recapture premium.

A fuller worked example

Say a residential rental has a $1,000,000 depreciable basis. A cost seg study reclassifies $150,000 into 5-year personal property (1245), $50,000 into 15-year land improvements (1250), and leaves $800,000 as the 27.5-year building (1250). Suppose you claimed bonus depreciation on the shorter-life buckets, then sell several years later at a gain. The $150,000 of personal-property depreciation is recaptured as ordinary income to the extent of gain on those assets. The depreciation on the land improvements and the building is unrecaptured Section 1250 gain taxed at up to 25%. Any appreciation above original cost is long-term capital gain (0–20%). The cost seg did not create more total recapture than plain depreciation would have — it shifted a slice of it from the 25% bucket into the ordinary bucket, in exchange for pulling the deductions years forward.

Gain is computed asset by asset at sale

When you sell, the contract price is allocated among the asset classes — personal property, land improvements, building, and land — and each asset computes its own gain and recapture on Form 4797. Section 1245 recapture on a personal-property component is limited to the actual gain on that component: if a five-year-old appliance package has fallen in real value, the ordinary recapture is capped at whatever gain the allocation assigns to it, not the full depreciation taken. A defensible allocation (often supported by the original study) is what keeps the ordinary-income slice from being overstated.

Bonus depreciation makes recapture faster

Pairing cost segregation with bonus depreciation expenses most of the 5-, 7-, and 15-year components immediately. That is powerful up front, but it also means that if you sell within a few years, nearly all of those front-loaded deductions come back as recapture — and the personal-property share of it is ordinary-rate 1245 recapture. The shorter your expected hold, the more the recapture math eats into the benefit, so bonus-heavy cost seg rewards a longer hold or an eventual 1031 exchange.

Strategies to manage the recapture

Three levers soften the bill. A 1031 exchange defers all of it — both 1245 and 1250 recapture roll into the replacement property's basis. A long hold lets the time value of the early deductions outrun the rate premium. And a step-up in basis at death can eliminate the deferred recapture entirely for heirs. Note what does not help: an installment sale does not spread recapture — Section 1245 and 1250 recapture must be recognized in full in the year of sale, even if you collect the price over time.

Don't forget the NIIT and state tax

The rate story does not end with the federal recapture rate. Higher-income owners may owe the 3.8% net investment income tax on the entire gain, including the recapture portion, once modified AGI exceeds $200,000 (single) or $250,000 (married filing jointly). On top of that, most states tax the recapture as ordinary income at state rates and many decouple from federal bonus depreciation — meaning your state basis, state depreciation, and therefore state recapture are calculated on different numbers than the federal return. Model the full stack (ordinary or 25% federal rate + 3.8% NIIT + state) before assuming cost seg is a slam dunk on a near-term sale.

Catch-up cost seg via Form 3115

You can cost-segregate a property you have already owned for years without amending old returns. Filing Form 3115 (a change in accounting method) lets you claim a Section 481(a) catch-up adjustment — the difference between the depreciation you took and what you could have taken had the study been done from the start — all in the current year. That is a large up-front deduction, but it also increases your accumulated depreciation, and therefore the recapture waiting at sale. The technique is powerful for a long hold, but the recapture arithmetic above applies in full to the caught-up amounts.

Common modeling mistakes

Investors routinely overstate the benefit of cost segregation by ignoring the exit. The frequent errors: modeling the up-front deductions but not the recapture that reverses them at sale; assuming all recapture is capped at 25% when the personal-property slice is ordinary-rate 1245; forgetting the NIIT and state layers; and planning a short hold that leaves little time for the time-value advantage to accrue. Keep the original study and its component allocations on file — you will need them years later to defend the asset-by-asset gain calculation on Form 4797, and to cap the ordinary 1245 recapture at each component's actual gain.

Why the deal usually still works

Framed correctly, the recapture is not a reason to avoid cost segregation — it is a reason to hold and to plan the exit. The benefit is fundamentally a time-value and rate-arbitrage play: you deduct against ordinary income today (often at 32–37% if you have active income to shelter through real estate professional status or the short-term rental rules), and you pay the tax back later, at the 25% cap on the 1250 portion and at ordinary rates only on the smaller 1245 slice. The longer the gap between the deduction and the recapture, the more the deferral is worth. On a property you intend to hold for a decade or exchange, the arithmetic is strongly positive; on a two-year flip, it can be roughly a wash once recapture, NIIT, and state tax are counted.

Recapture in a partnership or S corporation

Many rentals are held in an LLC taxed as a partnership or in an S corporation, and the recapture flows through to the owners on their Schedule K-1. The character carries through: the 1245 ordinary recapture and the unrecaptured 1250 gain are separately stated so each partner reports them at their own rates and NIIT status. If ownership percentages changed over the hold, or a partner was admitted after the study, the allocation of the front-loaded deductions and the later recapture can differ by partner — another reason to keep the study and the capital-account history. Coordinate with the entity's accountant so the K-1 correctly splits the recapture buckets rather than lumping everything into a single gain figure.

Suspended passive losses soften the sale

There is a favorable offset that owners often forget when they dread the recapture bill. If your rental generated passive losses you could not use in prior years — common precisely because cost segregation created large paper losses — those suspended passive losses are released in the year you fully dispose of the property in a taxable sale. They offset the gain, including the recapture portion, before you compute the tax. In many cost-seg exits, a chunk of the deductions that were trapped by the passive activity rules while you held the property come flooding back to shelter the very recapture those deductions produced. Pull your Form 8582 carryforward figures before modeling the sale — ignoring them overstates the tax you will actually owe.

How the buckets appear on your return

At sale, the mechanics run through Form 4797. The Section 1245 personal-property components are reported in Part III, where ordinary recapture is computed asset by asset; the building and land improvements (Section 1250, straight-line) generate unrecaptured Section 1250 gain that flows to the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions and is taxed at up to 25%; and appreciation above original cost becomes long-term capital gain on Schedule D. Because the ordinary 1245 recapture is taxed at your marginal rate, a large single-year sale can push you into a higher bracket, which is one more reason to weigh spreading the exit (via a partial 1031) or timing it in a lower-income year.

Frequently asked questions

Sources

• IRS Topic No. 409 — Capital Gains and Losses
• IRS Publication 544 — Sales and Other Dispositions of Assets
• IRS Publication 946 — How to Depreciate Property

Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.

Related

• Cost Segregation Calculator
• Depreciation Recapture Calculator
• 1031 Exchange Calculator