When it comes to maximizing tax savings through real estate investments, depreciation is one of the most powerful tools available. However, many investors fail to consider the tax liability that can arise later in the form of depreciation recapture. Fortunately, with proper planning, it’s possible to reduce, or even avoid, this costly surprise.
What Is Depreciation Recapture?
Depreciation recapture occurs when you sell a property for more than its adjusted basis (original cost minus depreciation taken). The IRS “recaptures” the tax benefit you received from depreciation by taxing the gain attributable to it at a higher rate, typically up to 25% for real estate.
For example, if you claimed $500,000 in depreciation over the years and later sell the property at a gain, the IRS may tax that $500,000 at the depreciation recapture rate, even if your long-term capital gains rate is much lower.
Why It Matters for Cost Segregation
Cost segregation is a powerful strategy that accelerates depreciation deductions in the early years of ownership by identifying and reclassifying building components into shorter-life property (such as 5, 7, or 15 years instead of 27.5 or 39). This front-loaded benefit significantly boosts cash flow.
However, because more depreciation is taken sooner, the potential for recapture is greater if the property is sold without a proper exit strategy. That doesn’t mean you shouldn’t use cost segregation, it just means you need to plan ahead.
Strategies to Avoid or Minimize Depreciation Recapture
1. Utilize a 1031 Exchange
A like-kind exchange (Section 1031) allows you to defer capital gains and depreciation recapture taxes by reinvesting the proceeds into another qualifying property. This strategy effectively pushes the tax liability into the future, and in many cases, can be repeated until death, at which point the heirs receive a step-up in basis, effectively eliminating the deferred tax liability.
2. Hold Until Death
If you hold the property until your passing, your heirs receive the property at its stepped-up fair market value. This eliminates the depreciation recapture liability entirely, making it an attractive estate planning strategy.
3. Offset Gains with Passive Losses
If you’ve accumulated passive losses (such as from other real estate investments or through certain tax strategies), you may be able to use those losses to offset the gain and reduce the amount of recapture.
4. Use Installment Sales
An installment sale allows you to spread out the capital gain over multiple years. While depreciation recapture is generally due in the year of sale, structuring the deal properly can reduce the overall impact by smoothing out your taxable income and potentially staying in a lower tax bracket.
5. Maximize Deductions Before Sale
Strategically increasing deductible expenses in the year of sale, such as capital improvements, professional fees, or business-related expenses, can help offset some of the income from depreciation recapture.
6. Plan Exit Timing Around Tax Law Changes
If you anticipate changes in tax law (such as a reduction in capital gains or recapture rates), it may be beneficial to delay or expedite the sale of your property accordingly. Having a proactive tax advisor can help you navigate these timing decisions effectively.
Work With Cost Segregation Experts
At CSSI, we help property owners across the U.S. unlock tax-saving opportunities through engineering-based cost segregation studies. But we don’t stop there, we work closely with your CPA or tax advisor to ensure that your exit strategy is just as smart as your investment strategy.
Whether you’re considering a cost segregation study or planning to sell a depreciated property, understanding how to avoid depreciation recapture is essential. The key is not to fear depreciation, but to use it wisely, with expert guidance and a clear plan.
Want to learn more about protecting your profits when selling a property, or how to maximize your tax savings? Contact CSSI today and let us help you build a tax-smart strategy from start to finish.
