This is Part 1 of a five-part series on depreciation recapture in cost segregation. It is educational and does not constitute tax advice — confirm any position with your tax advisor.
How Is Gain Taxed on a Sale After Cost Segregation?
On a taxable sale at a gain after cost segregation, gain generally splits into up to three layers: ordinary income, mainly §1245 recapture on 5- and 7-year components up to the depreciation taken; unrecaptured §1250 gain, taxed at up to 25% for a noncorporate taxpayer; and residual §1231 gain. Cost segregation accelerates deductions; it does not erase them.
Cost segregation moves basis out of the 27.5- or 39-year building shell into shorter-lived 5-, 7-, and 15-year classes, producing larger deductions early. The mirror image of that benefit shows up at sale: the same study that front-loaded your deductions also shapes the tax character of your future gain. Many investors model the acquisition carefully and the exit barely at all — and that gap can distort projected after-tax proceeds and partnership waterfalls.
The core idea from IRS Publication 544 is simple to state. Gain on a depreciable property is not one number with one rate. It is computed and characterized in layers.
Start With the Arithmetic
Two formulas drive everything that follows:
- Adjusted basis = original basis + capital additions − depreciation allowed or allowable − other reductions.
- Gain = amount realized (cash + noncash + liabilities relieved − selling expenses) − adjusted basis.
Note the word "allowable." Even depreciation you failed to claim still reduces basis — so skipping deductions does not avoid the gain it would have created.
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Layer 1 — Is Your 5- and 7-Year Property Subject to §1245 Recapture?
The 5- and 7-year components a cost segregation study reclassifies are section 1245 property; 15-year land improvements are not (they are §1250 property, covered in Layer 2). On sale, the gain on those components is taxed as ordinary income up to the depreciation taken:
Section 1245 ordinary recapture = the lesser of (gain, depreciation taken). — Framework of IRC §1245; IRS Publication 544
This is the layer that surprises people: the assets that delivered the biggest early write-offs are generally taxed back at ordinary rates, not capital-gain rates — the mechanic covered at length in §1245 recapture, the exit tax cost seg investors plan around.
Layer 2 — Why Is the Building's Gain Unrecaptured §1250 Gain, Not Ordinary Recapture?
Real property under MACRS is depreciated straight-line, so traditional §1250 ordinary recapture is usually zero. But the prior straight-line depreciation does not disappear — it becomes unrecaptured §1250 gain, taxed at a maximum federal rate of 25%, higher than ordinary long-term capital-gain rates. It applies to the accumulated depreciation on the structural building, to the extent of gain. 15-year land improvements are §1250 property too, but because they are depreciated faster than straight-line (150% declining balance, or bonus), the depreciation taken on them above straight-line is recaptured as ordinary income under §1250, and the rest is unrecaptured §1250 gain. The dedicated guide is unrecaptured section 1250 gain.
Layer 3 — Is the Rest of the Gain §1231 Capital Gain?
Whatever gain remains after the §1245 and unrecaptured §1250 layers is generally residual §1231 gain, eligible for capital-gain treatment. This is the only layer that gets the lowest rates.
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A Worked Example
Take a property whose depreciable basis was allocated $700,000 building shell, $150,000 land improvements, and $150,000 §1245 personal property, with accumulated depreciation of $80,000, $90,000, and $150,000 respectively, and component sale proceeds of $900,000, $130,000, and $120,000.
- §1245 components: basis $0, gain $120,000 → $120,000 ordinary recapture.
- Land improvements (15-year, §1250 property): gain $70,000; of the $90,000 depreciation taken, assume $10,000 is above what straight-line would have allowed → $10,000 §1250 ordinary recapture and $60,000 unrecaptured §1250 gain.
- Building shell: gain $280,000 → $80,000 unrecaptured §1250 (prior depreciation), $200,000 residual §1231.
The whole property's $470,000 gain splits into $130,000 ordinary, $140,000 unrecaptured §1250 (≤25%), and $200,000 residual §1231 — three rates, not one. A single blended capital-gain assumption would materially misstate the after-tax result.
Is Recapture a Reason to Avoid Cost Segregation?
Recapture is not a reason to avoid cost segregation — it is a reason to model the full life cycle. Over the next four parts we cover how to allocate the sale across land, shell, and short-life assets and how a partial disposition writes off the old component without double-counting. The last two parts cover how hold period decides whether acceleration is timing or drag and how distressed exits — abandonment, foreclosure, and COD income — are treated.
Related reading on the same mechanic: what happens to cost segregation deductions when an Opportunity Zone property is sold before year 10 and the OZ 10-year exclusion for limited partners, under which a qualifying limited partner may elect, after a 10-year hold and under the §1400Z-2(c) election and its regulations, to exclude capital gain from a fund's asset sale. On the deduction side that creates these layers, see what bonus depreciation in 2026 means for real estate owners. A seller in a partial like-kind exchange meets the same layers on the boot: which part of 1031 boot can go into a QOF.
Every ClickDrag study can be run through our recapture engine for an illustrative exit picture — model your acquisition side first — and every figure should be confirmed with your tax advisor before you rely on it. If you are choosing a provider, how cost segregation firms compare sets out the market, and a cost segregation study sizes the deduction side whose character these three layers determine at sale.
Frequently Asked Questions
How is the gain taxed when a property is sold after cost segregation?
On a taxable sale at a gain, recapture applies, up to the amount of that gain, however long the property was held, outside the Opportunity Zone 10-year rule (a qualifying investment held 10 years with the IRC §1400Z-2(c) election): §1245 recapture on the 5- and 7-year property is ordinary income, as is §1250 recapture of the depreciation taken above straight-line (bonus included) on 15-year land improvements held more than one year, and the rest of the depreciation on those land improvements and on the 27.5- or 39-year structure is unrecaptured §1250 gain, taxed at up to 25% for a noncorporate taxpayer. Whatever gain remains after those layers is generally residual §1231 gain, eligible for capital-gain treatment.
Are 15-year land improvements from a cost segregation study §1245 property?
Fifteen-year land improvements are generally §1250 property, not §1245 property: on a taxable sale at a gain, when they are held more than one year, the depreciation taken on them above straight-line, bonus included, is recaptured as ordinary income under §1250 and the rest is unrecaptured §1250 gain, taxed at up to 25% for a noncorporate taxpayer, while the 5- and 7-year components a cost segregation study reclassifies are §1245 property.
Does skipping depreciation reduce the gain when you sell?
Skipping depreciation does not reduce the gain, because adjusted basis is reduced by the depreciation allowed or allowable, so depreciation you were entitled to and did not claim still lowers basis and raises the gain on a sale.
Is depreciation recapture a reason to avoid cost segregation?
Depreciation recapture is a reason to model the full life cycle rather than a reason to avoid cost segregation: a cost segregation study accelerates deductions, so on a taxable sale at a gain the depreciation on the 5- and 7-year components is generally taxed back as ordinary income up to the depreciation taken, and the hold, the rates and the exit decide whether the timing benefit nets positive.
