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.
Acceleration Has a Mirror Image
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.
* * *
Layer 1 — §1245 Ordinary Recapture (your 5/7/15-year property)
Most components a cost segregation study reclassifies into shorter lives are treated as §1245 property. 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.
Layer 2 — Unrecaptured §1250 Gain (your 27.5/39-year building)
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.
Layer 3 — Residual §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.
* * *
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 (treated as §1245 here): gain $70,000, depreciation $90,000 → $70,000 ordinary recapture.
- Building shell: gain $280,000 → $80,000 unrecaptured §1250 (prior depreciation), $200,000 residual §1231.
The whole property's $470,000 gain splits into $190,000 ordinary, $80,000 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.
Why This Series Exists
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 sale proceeds across components, how partial dispositions work, how hold period changes the calculus, and how distressed exits (abandonment, foreclosure) are treated.
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.
