Cost Segregation Can Help Minimize Recapture Tax
When a property owner sells an asset, they face depreciation recapture tax. This applies to assets previously used to offset ordinary income through depreciation.
Depreciation recapture closes a tax loophole. Previously, taxpayers could take depreciation deductions against ordinary income. Then they sold those assets at lower capital gain rates.
Now the rules have changed. Taxpayers can still deduct asset depreciation from ordinary income. But they must report disposal gains (up to the recomputed basis) as ordinary income, not capital gains.
Through depreciation recapture, portions of the gain face ordinary income tax rates. These rates reach 25% for real property and 39.6% for personal property. Any gain over the recomputed basis gets taxed as a capital gain.
Depreciation recapture most commonly applies to improved real estate sales. This includes rental property. Real estate values generally increase over time. Meanwhile, the improvements face depreciation. Sections 1245 and 1250 of the Internal Revenue Code govern depreciation recapture.
Knowledgeable taxpayers know depreciation recapture isn’t always bad. Sometimes the net present value of tax savings exceeds the recapture tax. The recapture doesn’t entirely cancel out benefits realized during the depreciation period.
Impact of Cost Segregation
Cost segregation can magnify recapture tax liability. However, strategies exist to mitigate the impact.
Consider this scenario: An asset underwent front-loaded depreciation and is now sold. The IRS may determine too much depreciation was taken. We then recalculate the depreciation using the straight-line method. The difference gets taxed at ordinary income rates, not the lower capital gain rate.
Cost segregation studies categorize assets separately. They’re listed as either real property or personal property assets. This ensures accurate recapture tax calculations. The study benefits often offset any costs to the taxpayer.
Cost segregation studies break out assets for allowable dispositions. Buildings constantly change through improvements and renovations.
Here’s how it works: An owner has basis in certain assets today. If those assets aren’t there when they sell, they can claim an allowable disposition. This happens in the year it occurs and provides an immediate deduction. When they sell, there’s no recapture on those missing assets.
Cost segregation studies have two main goals. The primary goal is reducing current income. The secondary goal is creating documentation of asset costs. This allows future allowable dispositions.
Impact of a 1031 Exchange
1031 like-kind exchanges offer another strategy. When property owners use this method, they generally recognize no gain or loss at exchange time. Taxpayers can avoid immediate recapture tax impact.
However, this strategy just delays the inevitable. The recapture applies when the property eventually sells.
1031 exchanges work well in certain circumstances. They’re ideal when taxpayers don’t need immediate sale gains. They’re also good for those interested in owning subsequent property.
