Can Cost Segregation Offset Capital Gains?

Understanding the tax implications of real estate investment, especially upon sale, is essential. Capital gains taxes are a key consideration when an appreciated asset is sold. Cost segregation is a tax strategy for real estate owners. This article explores how cost segregation interacts with capital gains and depreciation recapture when a property is sold.

Cost Segregation and Accelerated Depreciation

Cost segregation accelerates depreciation deductions for real estate investors. Real estate assets are normally depreciated over long periods: 27.5 years for residential rental properties and 39 years for commercial properties.

A cost segregation study reclassifies building components into shorter depreciation lives, typically 5, 7, or 15 years. For instance, personal property like carpeting or interior fixtures might be reclassified to a 5-year life, while land improvements such as landscaping or parking lots could fall under a 15-year schedule.

This reclassification accelerates depreciation deductions. By moving a portion of the property’s value into shorter recovery periods, owners claim larger tax deductions in earlier years. This front-loading reduces taxable income, improving cash flow. While total depreciation remains the same, its timing is altered, providing immediate tax savings.

Capital Gains on Real Estate Sales

Capital gains represent the profit realized from the sale of a capital asset, with real estate being a common example. This gain is calculated by subtracting the property’s adjusted basis from its sales price. The adjusted basis generally begins with the original cost of acquiring the property, including purchase price and certain closing costs.

This initial basis is then adjusted over the period of ownership. Improvements that add value to the property increase the basis, while deductions such as depreciation decrease it. The reduction of the adjusted basis due to depreciation is a key factor in determining the taxable gain upon sale. If a property is held for more than one year, the gain is considered a long-term capital gain, subject to preferential tax rates.

For the 2025 tax year, federal long-term capital gains tax rates are 0%, 15%, or 20%, depending on the taxpayer’s overall taxable income. If an asset is held for one year or less, any profit is a short-term capital gain, taxed at ordinary income tax rates, which can be as high as 37% for 2025.

Depreciation Recapture and Its Tax Treatment

Depreciation recapture applies when a depreciated asset, such as real estate, is sold for a gain. It reverses the tax benefit from prior depreciation deductions. When a property sells for more than its adjusted basis, the gain attributable to previously claimed depreciation is treated differently from the remaining capital gain.

For real estate, this is governed by Internal Revenue Code Section 1250. The gain equivalent to depreciation taken is generally taxed at a maximum federal rate of 25%, referred to as “unrecaptured Section 1250 gain.” This 25% rate applies regardless of the taxpayer’s ordinary income tax bracket, up to the amount of depreciation claimed. Any additional gain beyond total depreciation is then taxed at standard long-term capital gains rates of 0%, 15%, or 20%, depending on income.

Accelerated depreciation from cost segregation increases the amount subject to the 25% depreciation recapture rate. Larger depreciation deductions in earlier years mean a greater portion of the eventual sale gain will be recharacterized as unrecaptured Section 1250 gain. While cost segregation provides immediate tax savings during ownership, it can result in a larger portion of the gain being taxed at the 25% rate upon sale, rather than at potentially lower long-term capital gains rates. Cost segregation does not “offset” capital gains; instead, it recharacterizes a portion of the gain to be taxed at the specific 25% recapture rate.

Evaluating Cost Segregation in Property Sales

Property owners should consider the implications of a cost segregation study, especially if they anticipate selling the property. The anticipated holding period significantly influences the overall tax benefit when accounting for depreciation recapture. A shorter holding period means less time to fully utilize cash flow benefits from accelerated depreciation before facing recapture tax.

A thorough cash flow analysis is recommended to weigh immediate tax savings from accelerated depreciation against potential recapture tax upon sale. This analysis should project the net present value of tax benefits and costs over the expected ownership period. Factors like the investor’s current and projected tax brackets and expected property appreciation play a role. The initial cost of a cost segregation study should also be factored into this financial assessment.

One strategy that can defer recapture tax, along with capital gains, is a 1031 exchange, also known as a like-kind exchange. This allows an investor to defer taxes on the sale of a property if the proceeds are reinvested into a similar “like-kind” property. While a 1031 exchange can defer both capital gains and depreciation recapture, the investor must acquire replacement property of equal or greater value, including depreciable property, to fully defer the tax liability.

Consulting with tax professionals, such as CPAs and cost segregation specialists, is advisable. These experts can perform a detailed analysis specific to a property and the owner’s financial situation. They require documentation like the property’s purchase price, type, intended use, and estimated holding period to provide accurate projections and guidance. This professional guidance helps ensure compliance with IRS regulations and optimizes the tax outcome.