Most real estate investors know that cost segregation accelerates depreciation deductions, unlocking substantial tax savings and improved cash flow during the early years of property ownership. But far fewer realize that cost segregation also creates a unique opportunity for planning at the time of sale, when taxes on those prior deductions come due through depreciation recapture.
With strategic planning, you can reduce the portion of gain that’s subject to ordinary income tax under §1245 and preserve more of your profits as long-term capital gains. This is done not through aggressive structuring, but through a simple, IRS-supported practice: assigning fair market value (FMV) to assets at the time of sale.
The Depreciation Recapture Trap
When a cost segregation study is performed, components of a building are reclassified from long-lived property (e.g., 27.5- or 39-year §1250 property) to shorter-life §1245 personal property, such as five-, seven-, or 15-year assets. These may include carpeting, cabinetry, specialty lighting, appliances, and land improvements like sidewalks, fencing, and landscaping.
This reclassification allows accelerated depreciation, often front-loaded using bonus depreciation, which can generate hundreds of thousands of dollars in deductions shortly after acquisition. However, at sale, any prior depreciation on §1245 property becomes fully recapturable as ordinary income, up to the total amount of gain on those assets.
This means that investors who received substantial early tax savings could be facing a significant ordinary income tax liability at exit—unless they take deliberate steps to manage how the sale price is allocated across their assets.
The Key Strategy: Assigning FMV at Sale
A common misconception is that all §1245 property is assumed to have no value at the time of sale. In truth, the IRS requires the sales price to be allocated based on the fair market value of each asset class. This is laid out explicitly in Treasury Regulation §1.1245-1(a)(5), which states:
“If section 1245 property and other property are disposed of in one transaction, the total amount realized shall be allocated between the section 1245 property and the non-section 1245 property in proportion to their respective fair market values.”
In other words, when a building and its associated personal property are sold together, sellers must determine how much of the total sales price should be assigned to §1245 property based on what those assets are actually worth, not based on historical cost or depreciation.
This is where the opportunity lies. If the FMV of those §1245 assets has decreased significantly—because of wear and tear, obsolescence, or market conditions—then assigning a lower FMV to those assets means less of the sales price is subject to recapture.
A Practical Example
Consider a commercial property purchased for $5 million. A cost segregation study identified $500,000 in §1245 personal property, which was fully depreciated over the first five years of ownership through bonus depreciation. Now, 10 years later, the property is being sold for $6 million.
If no FMV assignment is made, and $500,000 of the sale proceeds are implicitly assigned to the §1245 assets, then the entire $500,000 would be subject to depreciation recapture at ordinary income rates—potentially as high as 37%.
However, if an updated valuation shows that those personal property assets have a remaining FMV of only $150,000 at the time of sale, and the seller properly documents and supports that valuation, then only $150,000 of the proceeds is subject to recapture. The remaining $350,000 is treated as additional value of the real property (or land improvements) and taxed as long-term capital gain rather than ordinary income.
This single shift in valuation could save the seller more than $70,000 in taxes, depending on their tax bracket.
Supporting IRS Guidance
This approach is not a loophole—it’s squarely aligned with IRS expectations. In addition to Treasury Regulation §1.1245-1(a)(5), several other sources reinforce this:
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- IRS Publication 544 explains that gain on the sale of depreciable property is recognized to the extent the amount realized exceeds the adjusted basis, per asset.
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- Instructions for IRS Form 4797 make it clear that sellers must allocate proceeds among asset classes when reporting depreciation recapture.
- Instructions for IRS Form 4797 make it clear that sellers must allocate proceeds among asset classes when reporting depreciation recapture.
Why It Matters Even More Now
With 100% bonus depreciation having been phased down to 60% in 2024 and scheduled to drop to 40% in 2025, many investors have accumulated large amounts of accelerated depreciation over the past several years. As these properties near sale, the recapture tax liability becomes an increasingly important planning concern.
At the same time, fewer buyers are using 1031 exchanges, real estate values are fluctuating, and after-tax proceeds are a critical metric for most sellers. Now more than ever, investors need to be proactive—not reactive—when it comes to tax planning at the time of sale.
Who Should Be Paying Attention?
This FMV assignment strategy is especially useful for:
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- Owners of properties acquired 5–15 years ago who performed cost segregation
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- Commercial and multifamily property investors who took advantage of bonus depreciation
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- Sellers not using a full 1031 exchange
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- Tax advisors or transaction consultants helping clients plan for sale outcomes
How to Document FMV Properly
Fair market value assignments must be reasonable, well-documented, and defensible. The IRS expects sellers to support how they allocate sale proceeds across different asset classes, especially when depreciation recapture is involved. If audited, you’ll need to clearly justify the values assigned to §1245 property—unsupported or arbitrary allocations may be challenged and reallocated by the IRS.
Make sure your valuations are backed by credible methodology and reflect the actual condition and remaining economic value of the assets at the time of sale. Proper documentation can significantly reduce your exposure to unnecessary recapture and help protect your tax position.
Final Thoughts
Cost segregation has long been seen as a powerful front-loaded tax strategy, but the reality is that your exit plan matters just as much. Without proper planning, investors can give back a significant portion of their early tax savings through ordinary income tax at sale.
By assigning FMV to §1245 assets at disposition, sellers can reduce their depreciation recapture exposure, shift more of the gain to capital treatment, and significantly improve their after-tax outcome.
The IRS provides the framework. The opportunity is real. And with the right support, this can be one of the most impactful tax planning tools available to property owners today.
