§1245 recapture and the cost-seg downside
Cost segregation reclassifies basis into §1245 buckets — and §1245 recaptures all accumulated depreciation as ordinary income on disposition. For short holds, recapture can erase the year-1 benefit. These are the questions to ask before the sale, not after.
What is depreciation recapture?
Depreciation recapture is the rule that re-characterizes part of the gain on sale of a depreciable asset as ordinary income (or unrecaptured §1250 gain) instead of long-term capital gain, to the extent of depreciation taken. The two operative sections are IRC §1245 (personal property — full recapture as ordinary income) and IRC §1250 (real property — limited to depreciation in excess of straight-line, which since 1986 is generally zero, leaving "unrecaptured §1250 gain" taxed at a maximum 25% rate under IRC §1(h)(1)(E)).
What's the difference between §1245 and §1250 property?
§1245 property is, broadly, depreciable personal property and certain other tangible property used in a trade or business — appliances, carpet, decorative lighting, fences, signs, and the components a cost-seg study reclassifies as 5-, 7-, or 15-year. §1250 property is depreciable real property — buildings and structural components, the 27.5-year residential or 39-year commercial shell. The recapture mechanics differ: §1245 recaptures all depreciation taken as ordinary income on disposition; §1250 recaptures only depreciation in excess of straight-line, which is functionally zero post-1986.
Why is cost segregation §1245 property?
Because the asset categories cost segregation pulls into 5-, 7-, and 15-year MACRS classes are tangible personal property or land improvements that meet the Whiteco factors and the §1245(a)(3) definition. HCA v. Comm'r (109 T.C. 21, 1997) was the seminal case confirming that components meeting Whiteco are §1245 property regardless of whether they are physically attached to a §1250 building. The trade-off is intentional: faster cost recovery (5/7/15-year MACRS plus bonus) in exchange for full ordinary-income recapture on disposition under §1245(a)(1).
What's the recapture math if I sell within 3 years?
Roughly: the §1245 portion of accumulated depreciation comes back as ordinary income at marginal rates (up to 37% federal in 2026), and the §1250 portion is unrecaptured §1250 gain capped at 25% federal. With 100% bonus on reclassified assets in Year 1, an early sale (Year 2-3) recaptures essentially the full 5-, 7-, and 15-year reclassified basis as ordinary income — which can wipe out most of the time-value benefit if the owner's marginal rate is similar in the deduction year and the sale year, and can produce a worse outcome if the marginal rate is higher in the sale year.
Run a feasibility estimate at /cost-seg/.
Does a 1031 exchange defer recapture?
Yes — a fully qualifying like-kind exchange under IRC §1031 defers both capital gain and §1245 recapture, but only to the extent of like-kind replacement. After the TCJA, §1031 is restricted to real property. Treas. Reg. §1.1031(a)-3 treats §1245 personal property identified in a cost-seg study as part of the real property for §1031 purposes when it remains physically and functionally part of the relinquished real estate, which preserves deferral. Boot received in the exchange triggers recapture first under §1245(b)(4).
When does cost segregation lose money?
Cost segregation can produce a net negative outcome in a few scenarios: (1) an early disposition where §1245 recapture at a higher marginal rate exceeds the time-value benefit of the prior deduction; (2) the deduction is suspended as a passive activity loss carryforward and the owner has no path to use it (low passive income, no plan to sell); (3) study cost exceeds the net-present-value benefit, common on small residential rentals under ~$300K depreciable basis; (4) a state with no bonus-depreciation conformity creates a permanent state-federal differential. The threshold investors typically use is Year-1 federal tax savings of at least 2-3x the study fee, with a planned hold of 5+ years.
What's "ordinary income recapture" vs. "unrecaptured §1250 gain"?
Ordinary income recapture (IRC §1245) is taxed at the seller's marginal ordinary rate — up to 37% federal in 2026 plus the 3.8% net investment income tax under IRC §1411 if applicable. It applies to the §1245 portion of accumulated depreciation. Unrecaptured §1250 gain (IRC §1(h)(1)(E)) is the §1250 portion of accumulated depreciation, capped at a 25% federal rate. The remaining gain (above accumulated depreciation) is long-term capital gain at 0/15/20%. Cost segregation increases the §1245 share — meaning more of the depreciation comes back at ordinary rates and less at the 25% §1250 rate.
How do I avoid recapture surprise on disposition?
Plan the exit at the time of the study, not at the closing table. The standard sequencing investors use: (1) hold long enough for the time-value benefit of accelerated depreciation to materially exceed the recapture cost — 5+ years is a common floor; (2) consider §1031 exchange into replacement real property to defer the entire gain including §1245; (3) coordinate with NIIT (§1411) and AMT (§55) exposure in the planned sale year; (4) for installment sales, note that §1245 recapture is fully recognized in the year of sale under IRC §453(i), regardless of payment timing.
Run a feasibility estimate at /cost-seg/.