On a taxable sale at a gain, IRC §1245 taxes the depreciation taken on 5- and 7-year property from a cost segregation study as ordinary income, up to the gain on that property; the building's straight-line depreciation is unrecaptured §1250 gain, taxed at up to 25% for a noncorporate taxpayer. Cost segregation changes when tax is paid.
What Is the Trade-Off at the Heart of Cost Segregation?
Cost segregation is fundamentally a timing strategy. It does not eliminate tax — it defers it. When you reclassify $1 million of construction costs from 39-year to 5-year property and take that deduction today, you are borrowing from the tax you would otherwise owe in years 2 through 39. The benefit is the time value of money: a deduction today is worth more than the same deduction in year 15, at any positive discount rate.
The mechanism by which the IRS eventually collects on prior depreciation is called depreciation recapture, and it operates through two statutory provisions: IRC §1245 (for personal property, such as the 5- and 7-year components) and IRC §1250 (for real property, including the building and 15-year land improvements) — together with residual capital gain, the three layers a sale splits into.
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How Does §1245 Recapture Work?
Under IRC §1245(a)(1), when you sell §1245 property at a gain, the amount of gain equal to all depreciation previously allowed or allowable is recharacterized as ordinary income. This applies to section 1245 property, which includes the 5-year and 7-year personal property identified in a cost segregation study; 15-year land improvements are §1250 property, so only the depreciation taken on them above straight-line is recaptured as ordinary income, under §1250.
The key word is "allowable" — even if you did not actually claim the depreciation (an error or oversight), the IRS treats you as having claimed it, and recapture applies anyway. This is why missing depreciation in prior years can be doubly costly: you lose the original deduction and may still face recapture on sale.
"If §1245 property is sold, exchanged, or otherwise disposed of, the amount realized attributable to §1245 property is treated as ordinary income to the extent of the lower of the recomputed basis or the amount realized." — IRC §1245(a)(1); IRS Publication 544, Sales and Other Dispositions of Assets
§1250 Recapture: The 25% Rate on Real Property
For real property (27.5-year and 39-year assets), a different recapture rule applies. Under IRC §1250, if straight-line depreciation was used (as required for real property under MACRS), there is technically no §1250 recapture — but there is unrecaptured §1250 gain, which is taxed at a maximum rate of 25% under IRC §1(h)(1)(E). This applies to the entire accumulated straight-line depreciation on the structural building, not just the accelerated portion. The full mechanics are in unrecaptured section 1250 gain.
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What Does a Cost Segregation Net Present Value Analysis Model?
A rigorous cost segregation analysis always models recapture. The economic question is: what is the present value of the near-term tax savings, net of the present value of the future recapture liability?
This example is one set of assumptions, not a forecast:
- a $2 million 5-year allocation, fully depreciated over 5 years;
- a 10-year hold, and a sale that allocates at least $2 million of gain to that 5-year property;
- a 37% rate both when the deductions are used and at sale;
- a 7% discount rate.
At sale in year 10, the entire $2 million is recaptured at ordinary income rates (say 37%) — a $740,000 recapture liability. But that liability is 10 years away. At a 7% discount rate, its present value today is approximately $376,000.
Against the immediate tax savings from the reclassification (which could exceed $700,000 at current rates), the NPV of the cost segregation study is positive under these assumptions; a lower rate when the deductions were used, a higher rate at sale or a shorter hold narrows or reverses it.
Whether the math favors cost segregation depends on the hold period and on the rates at which the deductions were used and the rates at sale. Short holds compress the NPV benefit because the recapture occurs before the time-value advantage can accumulate.
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Mitigation Strategies
Sophisticated investors use several tools to manage recapture exposure:
- §1031 Like-Kind Exchange: A properly structured 1031 exchange defers gain by rolling the proceeds into a replacement property (IRC §1031(a)), and it defers §1245 recapture only to the extent the replacement property includes enough §1245 property to absorb it (IRC §1245(b)(4)). The recapture is deferred, not eliminated, but the deferral can extend indefinitely through successive exchanges. §1245 recapture recognized on boot is ordinary income, which is outside a QOF election (which part of 1031 boot can go into a QOF).
- Installment Sales: Selling on the installment method under IRC §453 spreads the gain recognition over multiple tax years, potentially reducing the marginal rate applicable to recapture income.
- Step-Up at Death: Unrealized appreciation — including deferred recapture — receives a step-up in basis at death under IRC §1014, potentially eliminating the recapture liability entirely for estate planning purposes.
- Charitable Remainder Trusts: In some circumstances, contributing appreciated property to a CRT can convert gain recognition into an annuity stream, reducing immediate recapture exposure.
"No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment." — IRC §1031(a)(1)
The Bottom Line on Recapture
§1245 recapture is real, and it will apply when you sell cost-segregated assets. That is a reason to plan, not a verdict either way. Model the full cycle (deduction today, recapture at exit) with a net-present-value analysis before ordering a study. Whether the time value of the front-loaded deductions exceeds the discounted recapture cost depends on the hold period, the rates at which the deductions were used and the rates at sale. Inside an Opportunity Zone the question has its own answers: what happens to cost segregation deductions when an OZ 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.
Start the model with your own deduction side — the free calculator estimates what a study would front-load for your property. From there, how cost segregation firms compare covers who models recapture alongside the deduction, and a cost segregation study gives you the first number that analysis needs.
Frequently Asked Questions
Does cost segregation create §1245 recapture when I sell?
Yes, on a taxable sale at a gain: the depreciation taken on the 5- and 7-year property a cost segregation study identified is recaptured as ordinary income under IRC §1245, up to the gain on that property, so the study moves deductions earlier and, at a taxable sale, moves that part of the gain into ordinary income.
Is 15-year property from a cost segregation study §1245 property?
No: 15-year land improvements are generally §1250 property, so on a sale of property held more than one year only the depreciation taken on them above straight-line (bonus depreciation included) is recaptured as ordinary income under §1250, and the rest of their depreciation is unrecaptured §1250 gain, taxed at up to 25% for a noncorporate taxpayer.
Is depreciation I never claimed still recaptured?
Yes, on a taxable sale at a gain: §1245 recaptures depreciation "allowed or allowable", so depreciation you were entitled to but did not claim is still treated as taken when you sell; missed depreciation can often be caught up first through an accounting-method change on Form 3115, on the conditions in section 6.01 of Rev. Proc. 2025-23, and if it is not, you lose the deduction and still face the recapture.
Can a 1031 exchange defer §1245 recapture after a cost segregation study?
Only to an extent: a like-kind exchange under IRC §1031 defers §1245 recapture only to the extent the replacement property includes enough §1245 property to absorb it (IRC §1245(b)(4)), and the recapture is deferred, not eliminated.
How does the hold period change the value of a cost segregation study?
The longer the hold before a taxable sale, the more the time value of the earlier depreciation can exceed the discounted cost of recapture, so a short hold, a lower rate when the deductions were used or a higher rate at sale narrows or reverses the benefit; model the deduction and the exit together before ordering a study.
