Cost Segregation Studies: Let's Talk About Depreciation Recapture

If you are holding real property, it might be hard to see the upside in this economy. Banks are tight-fisted with loans and both the commercial and residential real estate markets have a long road to recovery. But from a tax point-of-view, the one positive is that property owners are finally opening their minds to getting past recapture issues. For a long time recapture has been the “misunderstood child” in tax planning when it regards cost segregation due in great part to the complexity of the tax law in this area. As a result landlords and their tax planners have not fully realized the benefits, frequently saying, “I might be selling the property a few years so recapture taxes would kill me.” The slowing real estate market has presented an opportunity to re-examine recapture and assess whether the advantages outweigh the disadvantages, as they often do. Let’s begin by explaining recapture in terms that are a little more “user friendly”.

Recapture, more accurately known as depreciation recapture, is something that only kicks in on the sale of an asset. Recapture is limited to the lesser of the gain or the depreciation taken. So first you have to sell the asset and then have a gain on the sale to even be concerned with recapture. To have a loss, one would have to sell the property for less than its net tax value. For practical purposes, the depreciation taken is the main limiting factor because the IRS calculates gain as the selling price less the net tax value (cost less depreciation taken). The recapture rules dictate how the gain is taxed, with § 1245 governing personal property and § 1250 governing real property. Section 1245 dictates that the accelerated depreciation taken on personal and real property be taxed at ordinary income tax rates. Section 1250 requires that depreciation taken on real property be taxed at a 25% capital gains rate. Any gain in excess of the total depreciation is taxed at the normal capital gains rate, but this does not wholly dictate whether recapture eliminates a need to do a cost segregation study. This is illustrated in the example below.

Assuming your client has sold or is going to sell their building, let us use the facts below to show the benefit of a cost segregation study.

• Property purchased 6/1/2005
 
• Cost = $5,000,000 with a break down of:
 
» 5-year - $1,000,000
» 15-year - $750,000
» 39-year - $3,250,000
 
• Selling price of $10,000,000
 
• Effective tax rate of 40% (Fed. & State)
 
• Interest rate of 6%


Given the above assumptions, we can calculate the benefit on the sale derived from the cost segregation study (CSS) taking the accelerated depreciation now vs. depreciating the building at a 39-year life. The benefit of the CSS is compared to the increased tax generated by the CSS in the table below.


	Benefit of CSS	Extra Tax w/CSS	Net Benefit
If sold in 2008	$291,439	$261,636	$29,803
If sold in 2009	$380,711	$330,265	$50,446
If sold in 2010	$456,023	$380,984	$75,039

Note: Calculations based on accumulated depreciation at date of sale, not net present value.

One must remember that depreciation recapture occurs only to when the sales price is allocated to a specific item in an amount sufficient to produce a gain. Therefore it is essential that the selling price allocation be as part of an appraisal. When a building is sold, for purposes of calculating the gain on the sale, the sale price should be allocated to the specific items based on their fair market value at the time of the sale. While conventional wisdom might suggest that appreciation of real estate generally occurs due to economic appreciation on land, and inflation on the cost of materials and labor, other factors such as income stream and goodwill are often taken into consideration when appraising the property. According to the IRS, the fair market value is not determined by the net tax value but by an appraisal that assigns the fair market value to the property. The IRS will respect a purchase and sale agreement (P&S) in an arm’s length transaction. If a seller allocates the selling price in a P&S to the assets class by class and this is accepted by the purchaser, it will be considered binding on both parties by the IRS - so much so that you cannot do a cost segregation study in this case.

One more point, when a C Corporation sells real property prior to the end of its full recovery period, part of the time value benefit is also lost. However, because all income is taxed at the same rate in the “C” corporation, recapture is a non-issue.

The bottom line is that recapture depreciation does not automatically negate the gain from a cost segregation study. We are not denying that a CSS will produce additional recapture tax, but when you compare the benefit of the accelerated depreciation from a CSS, it usually exceeds the increased tax. This is a facts-and-circumstances calculation that each property owner needs to investigate before taking a cost segregation study off the table. A knowledgeable cost segregation professional can guide you through the figures to assess whether you are a good candidate for a study. All you need to do is keep an open mind.