Want to understand how cost segregation can benefit your specific property, even with recapture in mind?
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The Truth About Depreciation Recapture: Why Cost Segregation Still Delivers Powerful Tax Savings
One of the most common misconceptions among real estate investors and even some tax professionals is this:
“Cost segregation isn’t worth it because I’ll have to pay it all back when I sell.”
This belief—that depreciation recapture wipes out the benefits of accelerating depreciation—is both widespread and fundamentally flawed.
In this article, we’ll break down exactly how depreciation recapture works, why cost segregation remains one of the most powerful tax strategies available to real estate owners, and how to strategically plan for recapture so it doesn’t take you by surprise.
What Is Depreciation Recapture?
Depreciation recapture is a tax provision that applies when you sell a property for more than its adjusted basis. The IRS wants to “recapture” some of the tax savings you claimed over the years through depreciation deductions. It doesn’t mean you pay everything back. It means you may owe a portion of tax on the gain related to the depreciation you took.
The key points:
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- Real property (e.g., buildings) is generally recaptured under Section 1250, and taxed at a maximum of 25%.
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- Personal property (e.g., carpeting, cabinets, equipment, certain site improvements) is recaptured under Section 1245, and taxed at ordinary income rates, up to 37%, but often much lower depending on your bracket.
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- Depreciation recapture is only triggered when you sell the property, and only if you sell it at a gain.
Why Cost Segregation Is Still Worth It—Even with Recapture
Let’s address the elephant in the room: You don’t “lose” money because of recapture—you simply pay tax later on deductions you’ve already claimed. But along the way, those deductions can produce massive tax savings, cash flow, and investment leverage.
Here’s why the math still works in your favor:
1. The Time Value of Money
Taking a large deduction today is more valuable than the same deduction spread out over 39 years. That’s the core of cost segregation.
For example, if you take a $300,000 deduction in year 1 instead of $7,692 per year for 39 years, you’ve just unlocked cash that you can use now, to reinvest, pay down debt, or grow your portfolio. Even if you eventually owe some tax on that deduction, you’ve had years of benefit from that capital.
You’re essentially getting a tax-free loan from the government that you may pay back in part years later—and possibly at a lower rate.
2. You Often Don’t Pay It All Back
Many people assume they’ll have to “repay” all their depreciation savings in the form of recapture. Not true.
Depreciation recapture is only assessed to the extent of gain. If the building’s value has gone down or remained flat, there may be little or no recapture at all. Even if values go up, you may only pay recapture on the personal property portion.
Also, if the property is sold in an installment sale or exchanged via a 1031 exchange, recapture may be deferred or spread out over time.
3. Lower Tax Rates on Recapture vs. Initial Deductions
Most investors take cost segregation deductions when they’re in higher income tax brackets. But when they sell, especially in retirement or under a different structure, they might be in lower brackets, meaning they save more upfront than they owe later.
And remember: 1250 recapture (for real property) is capped at 25%, not taxed at ordinary income rates.
4. Strategic Planning Can Reduce Recapture Exposure
The best tax strategies involve proactive planning, not reactive regret. Here are some common ways savvy investors reduce or defer recapture:
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- 1031 Exchanges: Roll over gains, including recapture, into another property. No current tax owed.
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- Partial Asset Sales: Sell a portion of your interest to spread out recapture.
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- Installment Sales: Spread gain and recapture over several years.
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- Estate Planning: Hold the property until death, so heirs receive a step-up in basis, wiping out all prior depreciation and recapture exposure.
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- Reclassify/Upgrade Components: Renovate or improve parts of the property to restart depreciation and lower overall recapture amounts.
Let’s Look at a Real-World Example
Imagine you buy a commercial building for $2,000,000 (not including land). You do a cost segregation study and allocate:
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- $300,000 to 5-year property
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- $200,000 to 15-year property
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- $1,500,000 to 39-year property
In year 1, thanks to bonus depreciation, you deduct the full $500,000 in short-life property.
Let’s say your tax rate is 37%, so you reduce your tax liability by $185,000 in the year you place it in service.
Now fast forward 10 years. You sell the property for $2.2 million. After accounting for depreciation, your adjusted basis is lower, and you owe recapture tax on the $500,000 in short-life property you depreciated.
If your bracket is now 30%, you pay around $150,000 in recapture taxes.
That’s still a net benefit of $35,000, and that’s ignoring what you did with the $185K in year 1. If you reinvested it or used it to acquire more properties, the real benefit is much larger.
Bonus: If You Never Sell, You Never Recapture
Many real estate investors are buy-and-hold for life. If you hold the property until death, the depreciation deductions you’ve taken disappear with the step-up in basis your heirs receive.
That means:
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- No capital gains tax
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- No depreciation recapture
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- You’ve essentially gotten free tax deductions for life
That’s a powerful estate planning tool, and one of the many reasons cost segregation fits into multigenerational wealth strategies.
Why This Misconception Persists
This myth is so persistent because:
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- Recapture can be confusing, especially when both 1245 and 1250 rules apply.
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- People don’t realize recapture is not dollar-for-dollar repayment.
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- CPAs sometimes take a conservative stance or lack training in real estate tax strategy.
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- Investors don’t see the big picture of timing, cash flow, and reinvestment.
But as more professionals learn how to model the lifetime tax impact, rather than just looking at the exit, this misconception is slowly being corrected.
Final Thoughts: Recapture Doesn’t Cancel the Strategy
Yes, recapture is real. But cost segregation is still one of the most effective tools for real estate investors to improve cash flow, reduce taxable income, and grow their portfolios faster.
When paired with smart planning, whether through exchanges, estate strategies, or reinvestment, the benefits far outweigh the potential tax at sale.
Cost segregation front-loads your tax savings so you can take action today, not 39 years from now.
Want to understand how cost segregation can benefit your specific property, even with recapture in mind?
Let’s run the numbers together! Reach out today for a no-obligation benefit estimate.
