Cost Segregation and Depreciation Recapture

Depreciation recapture is an often misunderstood aspect of tax planning and comes into effect only during the sale of a property.  

Recapture is limited to the lesser of the gain or the depreciation taken. Meaning, first you have to sell the property and have a gain on the sale to even be concerned.

To have a loss, one would have to sell the property for less than its net tax value. For practical purposes, the depreciation taken is the main limiting factor because the IRS calculates gain as the selling price less the net tax value (cost less depreciation taken). The recapture rules dictate how the gain is taxed, with § 1245 governing personal property and § 1250 governing real property. Section 1245 dictates that the accelerated depreciation taken on personal and real property be taxed at ordinary income tax rates. Section 1250 requires that depreciation taken on real property be taxed at a 25% capital gains rate. Any gain in excess of the total depreciation is taxed at the normal capital gains rate, but this does not wholly dictate whether recapture eliminates a need to do a cost segregation study. This is illustrated in the example below.

Assuming your client has sold or is going to sell their building, let us use the facts below to show the benefit of a cost segregation study.

• Property purchased 6/1/2005

• Cost = $5,000,000 with a breakdown of:

» 5 – year  – $1,000,000

» 15 – year – $750,000

» 39 – year – $3,250,000

• Selling price of $10,000,000

• Effective tax rate of 40% (Fed. & State)

• Interest rate of 6%

Using these assumptions, we can calculate the benefit on the sale derived from the cost segregation study taking the accelerated depreciation now vs. depreciating the building at a 39-year life. The benefit of the study is compared to the increased tax generated by the study in the table below.

Benefit of Study Extra Tax w/Study Net Benefit
If sold in 2008 $291,439 $261,636 $29,803
If sold in 2009 $380,711 $330,265 $50,446
If sold in 2010 $456,023 $380,984 $75,039

Note: Calculations based on accumulated depreciation at date of sale, not net present value.

Keep in mind that depreciation recapture occurs only to when the sales price is allocated to a specific item in an amount sufficient to produce a gain. Therefore it is essential that the selling price allocation be as part of an appraisal. When a building is sold, for purposes of calculating the gain on the sale, the sale price should be allocated to the specific items based on their fair market value at the time of the sale. While conventional wisdom might suggest that appreciation of real estate generally occurs due to economic appreciation on land, and inflation on the cost of materials and labor, other factors such as income stream and goodwill are often taken into consideration when appraising the property. According to the IRS, the fair market value is not determined by the net tax value but by an appraisal that assigns the fair market value to the property. The IRS will respect a purchase and sale agreement (P&S) in an arm’s length transaction. If a seller allocates the selling price in a P&S to the assets class by class and this is accepted by the purchaser, it will be considered binding on both parties by the IRS – so much so that you cannot do a cost segregation study in this case.

One more point, when a C Corporation sells real property prior to the end of its full recovery period, part of the time value benefit is also lost. However, because all income is taxed at the same rate in the “C” corporation, recapture is a non-issue.

The bottom line is that recapture depreciation does not automatically negate the gain from a cost segregation study. We are not denying that a Cost Segregation Study will produce additional recapture tax, but when you compare the benefit of the accelerated depreciation from a Cost Segregation Study, it usually exceeds the increased tax.

Cost Segregation for Condos or Apartment Buildings

Condo development or apartment building can benefit from a Cost Segregation Study.

Condominiums fall under a multi-family category which also includes properties such as apartments, hotels and residential-type facilities that house people either temporarily or for an extended time up to and including life.

Many factors play in computing the depreciation on properties of this type including where they are located, how much land is included and what land improvements apply.

Condominiums can be located in suburban areas and they can be found just as often in metropolitan areas as high rise buildings. The difference in these two property scenarios should be obvious, the suburban location would include a significant number of land improvements and the high rise would only have a small portion of cost basis that could be allocated to land improvements.

Additional considerations in calculating a benefit for condominiums would be; how many units the property contains, what amenities are located on the property (e.g., swimming pools, tennis courts, clubhouses and or fitness centers).

If you own or know someone who owns a condominium property and would like to find out if they would benefit from a Cost Segregation Study, simply schedule a Discovery Call (888) 800-9825

Medical Offices

Medical facilities are one of the best industry qualifiers for both cost segregation and property tax mitigation.  So much so, that GMG has an entire page dedicated to this industry on our main website

Additionally, here are a few articles that speak to why Medical Facilities are good candidates:

Four Reasons Why Medical Practitioners Should Not Own Commercial Property

Specialized Tax Incentives For The Medical Health Care Industry

Medical facilities may include:

  • General Practitioners
  • Specialist
  • Dental
  • Optical
  • Veterinarian
  • Privately Owned Pharmacies
  • And many more