How Cost Segregation Effects Recapture

Recapture is one of the most common objections to getting a cost segregation study.  However, these objections are often misguided as there are techniques to minimize recapture at the time of sale.

Recapture is a tax that occurs at the sale of a depreciated building or building component. You are recapturing what you could depreciate at the time of sale as a recapture tax on gains made in the sale of the building.

A cost segregation study identifies personal property and land improvement assets that qualify for accelerated depreciation. This process creates large depreciation deductions for the current building owner.  The recapture rate on accelerated property is ordinary income rates, as opposed to the 25% recapture rate on real estate property (27.5- or 39-year property).  As a result, in the sale of the building, increased taxes could be paid on the gains made.

Two factors should be examined when it comes to recapture.

First, how long will the building he held after the cost segregation study is applied?  After applying a cost segregation study, holding a building for three to five years is recommended. This hold gives the building owner time to put his newly found cash flow to use before paying it (or at least some of it) back at the time of the building sale.  Earning any amount on the cash flow received from the depreciation deductions outweighs recapture effects at the building sale.  Use increased cash for are paying off debt, investing in new property, investing in new equipment for your business, or investing in new employees for your business.

The second factor to look at is the allocation of the sales price of the building.  When a building that had a cost segregation study applied, you are now selling each component of the building (personal property, real property, and land improvements).  Personal property typically has a 5-year tax life, and it generally loses value over time.   Carpet is a good example of a personal property asset that does not appreciate. After owning a building with carpet for five years, the carpet will become worn. When the building sells, the carpet will have less value than at the time of purchase, and the new owner will likely replace it. Therefore, it is reasonable to assign less gain to carpet and more gain to appreciating assets such as the building structure or land. Doing so reduces recapture at the time of sale.

Recapture will always occur at the time of sale, but if for some time a building is going to be held, five years, for example, recapture should not be a concern.  For five years, you can use the increased cash flow from accelerated depreciation to invest in your business, pay off debt, pay for capital improvements, etc., which will almost always outweigh the effects of recapture.

Authored By: Robert Taylor, MBA