Savvy tax professionals who recommend cost-segregation studies are well aware of the recapture tax rules that require taxpayers to pay back any tax deductions for accelerated depreciation when the property is sold. After all, in the right situation, the net present value of those tax savings far exceeds any recapture tax payback. While the effects of a cost-segregation study can magnify recapture issues, tax professionals should consider a number of worthwhile opportunities to reduce or avoid recapture tax that is realized upon sale of property.
Recapture: An overview
The recapture tax was enacted to close a tax loophole that arose by allowing taxpayers to take depreciation deductions that offset ordinary income while taxing gains from the subsequent sale of those depreciated assets at lower capital gain rates. The loophole was closed by taxing gains attributable to depreciation deductions previously taken at rates higher than those available for capital gains. Depreciation recapture often requires that a portion of the gain be taxed at rates as high as 25% (for Sec. 1250 real property) and 39.6% (for Sec. 1245 property). Nonetheless, many taxpayers are under the impression that all gains generated from the sale of real estate are taxed at capital gain rates, the maximum of which is 20%. (These rates do not apply to corporations.)
Valuation of personal property at time of sale
When a property is sold, the fair market value of Sec. 1245 property in a building, which must be taxed as ordinary income, may be uncertain. The seller can minimize recapture by allocating more of the sale price to Sec. 1250 real property instead of the Sec. 1245 property. In many situations, Sec. 1245 property in a building may have little to no value. For example, carpeting and certain other Sec. 1245 property installed a decade ago likely has minimal worth, especially if the new owner has plans to replace it. As such, it would be appropriate to allocate only a nominal amount of the building's sale price to carpeting. Thus, proper valuation of the Sec. 1245 property may yield lower overall recapture tax.
The tangible property regulations (repair regulations) allow taxpayers to carve out and dispose of components removed or demolished from a building. Taxpayers can take losses on the remaining basis amounts for roofs, windows, HVAC systems, and other building components that have since been replaced. By making partial dispositions, taxpayers also avoid subsequent recapture on these items. It is important to note that partial dispositions must be made in the year of disposition, as these cannot be modified by a change in accounting method.
Case study: Consider a building purchased in 2009 for $5 million and then renovated in 2012 that results in the demolition of $470,000 worth of interior components. Incorrectly continuing to depreciate these assets could mistakenly result in recognizing recapture tax upon sale. If $370,000 was 39-year real property and $100,000 was five-year property, the recapture tax would be approximately $127,500 ($370,000 × 25% + $100,000 × 35%). On the other hand, if a partial disposition was made timely, there would be zero recapture tax on these components. Instead, the taxpayer would pay capital gains on them in the amount of $94,000 ($470,000 × 20%). Thus, by properly claiming a partial disposition, the taxpayer will realize permanent tax savings of $33,500 upon sale.
While partial dispositions are required when a component of a larger tax asset is removed, retirements generally occur when building components are separately stated on the tax depreciation schedule. Similar to partial dispositions, it is important for taxpayers to carefully review depreciation schedules for these and remove them to avoid recapture. For items retired in prior years that are mistakenly still being depreciated, taxpayers are allowed to make an automatic change in accounting method at any time to correct this (Designated Change No. 205).
Insight: When tenant improvements are separately stated on the depreciation schedule, taxpayers should verify that these improvements are still in place. If the tenant has since left and the old space has been demolished, a retirement loss deduction should be realized.
Repair vs. capitalization
The repair regulations provide much-needed guidance as to what can be treated as a repair expense and what requires capitalization. Replacing a roof membrane or replacing one of three furnaces of a building's HVAC system are examples of repair and maintenance expenses. Improperly capitalizing these costs not only increases current tax liability, but also creates unnecessary recapture tax when the building is sold. In many situations, taxpayers have the opportunity to retroactively correct this treatment by making an automatic change in accounting method (Designated Change No. 184).
Like-kind exchange (Sec. 1031)
Generally, no gain or loss is recognized for taxpayers that exchange business or investment property solely for business or investment property of a like-kind under Sec. 1031; nevertheless, recapture tax may be required even when there is an even exchange of real estate. However, when a cost-segregation study is performed on a relinquished property, Sec. 1245 recapture tax can be avoided as long as there are equal amounts or more Sec. 1245 property in the newly acquired replacement property. This often requires a cost- segregation study on the newly acquired property, but to avoid surprises after it is complete, tax professionals should work closely with an experienced cost-segregation professional to estimate the allocations of various tax life categories for the newly acquired property in the exchange.
Recapture issues should be addressed before the contemplated sale of an asset. By following some practical strategies, savvy tax professionals can eliminate unnecessary recapture tax upon sale.
Gian Pazzia, CCSP, is a principal with KBKG and its national practice leader for cost-segregation services, as well as a subject matter expert on repair vs. capitalization issues. He has served as president of the American Society of Cost Segregation Professionals and currently holds a seat on its board of directors. Alexander Bagne, CCSP, J.D., MBA, is a director with KBKG. He has more than 10 years of experience in Big Four firms and is the director of KBKG's repair regulation practice. He is a member of the American Society of Cost Segregation Professionals and a board member of the U.S. Green Building Council. So Sum Lee, is a director with KBKG with over 18 years of public accounting experience in auditing, accounting, and taxation. She is a member of the AICPA and an expert in various industries including wholesale businesses, real estate investments, and restaurants.