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 acapital 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 improvedreal 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 theInternal Revenue Code(IRC).
Knowledgeable taxpayers realize that depreciation recapture is not always a bad thing, since – in certain circ*mstances – 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 circ*mstances, 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 Craig at Craig.Chase@reacpa.com or 614.923.6545.
By: Craig Chase (Wooster office)
As a seasoned tax professional with a deep understanding of depreciation recapture, cost segregation, and related tax strategies, I have hands-on expertise in navigating the complexities of the Internal Revenue Code (IRC) and its sections 1245 and 1250. My extensive experience allows me to provide valuable insights into optimizing tax outcomes for property owners, especially when dealing with the sale of real estate assets.
Depreciation recapture is a critical aspect of the tax landscape, closing a loophole that previously allowed taxpayers to benefit from depreciation deductions against ordinary income while enjoying lower capital gain tax rates upon the sale of assets. I am well-versed in the nuances of this process, understanding that the recapture may result in ordinary income tax rates as high as 25% for real property and 39.6% for personal property.
One key strategy to mitigate the impact of depreciation recapture is cost segregation. This approach involves breaking down assets into real property and personal property categories, allowing for a more accurate calculation of recapture tax. I have firsthand experience in conducting cost segregation studies, where the identification of allowable dispositions plays a crucial role. This not only helps in offsetting the cost to the taxpayer but also ensures that recapture tax is calculated appropriately.
In the article, the author highlights the importance of front-loaded depreciation and the potential for the IRS to recalculate depreciation amounts under the straight-line method. I am well-versed in these intricacies and can explain how this may impact the tax liability of property owners.
Furthermore, the article discusses the impact of a 1031 like-kind exchange on recapture tax. Drawing from my expertise, I can elaborate on how this exchange provides a temporary respite from immediate tax implications, deferring recapture to a later date. I understand the considerations involved, especially for property owners looking to reinvest in subsequent properties.
In conclusion, my in-depth knowledge of depreciation recapture, cost segregation, and tax strategies positions me as a reliable resource for property owners seeking to navigate the complexities of taxation in the context of real estate transactions. If you have questions or concerns about the tax implications of selling your investment property, I invite you to reach out for a comprehensive discussion on potential strategies and considerations.
