Owners are most likely to avoid having a cost segregation analysis performed because of the possibility of recapture. This paper will provide financial analysts with a perspective on this topic. Let’s begin with the design and purpose of the recapture tax. The recapture tax was created to stop taxpayers from deferring their ordinary income to pay capital gains taxes. A taxpayer can defer 39.5% of ordinary income tax, and then sell the property one year later. The maximum amount is 23.5% capital gain tax. The depreciation deduction is not intended to convert income tax into capital gains tax. This loophole was closed, and has since affected cost segregation.

Recapture

The IRS uses recapture to close the loophole mentioned above. This is how it works. If a property was purchased for $100,000, it would have taken $50,000 in depreciation before being sold for $125,000. This would result in a $50,000 recapture. The $25,000 remaining would be subject to capital gains tax. Recuperation is the repayment of an existing benefit, but this is only part of the story. Property owners don’t have to pay a tax penalty. It’s the shock of losing a perceived advantage. A taxpayer may be tempted to abandon such strategies if he or she expects a $75,000 benefit but instead gets a $25,000 benefit. There are many ways to resolve this problem, but planning and communication are the best. A property owner must be prepared to understand that although depreciation can offset their ordinary income for the current year, a portion of it will have to be repaid in future years. This information could change the way you decide to price and time the property. All business decisions are implicitly or explicitly based on a net present value calculation (NPV). Projects often have a very low NPV. An unexpected loss of a tax advantage could make the difference between approving a project or scrapping it. It is important that property owners are made aware of the potential tax consequences. However, all is not lost. We will be discussing below a variety of strategies that can protect taxpayers.

Valuation Of Assets On Sale

The sale of cost-separated property is not like the sale or purchase of one item. The asset’s gross sale price is heavily weighed into the recapture provision. Tax professionals often decide the appropriate price. This guide will help you along the way. Property that has not been fully depreciated may have a nominal value. A larger percentage of the property’s value could be assigned to the 1250 property. Real estate can sometimes be worth millions of dollars, so these terms “nominal value” or “larger percentage” are not very helpful. Valuing the sale price allocation will be difficult for the remaining 1250 properties. A seven-year-old parking lot made from asphalt may not be an easy task for a tax professional.

The case law provides guidance, but it relies on the government’s valuation of value. The government in Nielsen v. Commissioner in Los Angeles County found that a property owner may assess the value of their property, but they don’t have the specific ability to evaluate the components of the property. In this instance, it is prudent to accept government guidance regarding the property’s value. In this instance, MACRS Depreciation would be the prevailing guidance. MACRS can be used both for tax and valuation purposes. The double-declining nature of the asset would result in a significant decrease in value. This would be a benefit for the taxpayer. It is not the same thing as assigning a lower value. Property owners who have a zero-value asset are more likely to be faced with problems than they should. This will be discussed in the next section.

Retirement, Improvement, and Disposal

This is where cost segregation may be more advantageous than a liability. The term “allowed/allowable” is what prevents taxpayers using loopholes to pay capital gains tax and defer ordinary income. The term “allowed/allowable” can have serious consequences in the cases of property that is being sold, property that has been allocated for retirement, or property that has been deemed to be beneficial under the IRS code. The proper treatment for an HVAC unit that has gone bad and must be replaced is to immediately deduct the remaining property value. If the property is sold, recapture will be activated. The remaining value of the disposed item, calculated from the date of disposal would be the recapture. This is because the taxpayer would have not received the disposal deduction if the property was not properly disposed of. In other words, they would have been subject to double taxation. This applies to assets that are retired or deemed improvements. GAAP doesn’t always follow because there hasn’t been a fixed value for these assets. Tax professionals would have to determine the value of a 4000 sq. foot roof that is not measured and has no age. These issues are best dealt with by a professional in construction engineering, design and cost structures. Cost Segregation removes the burden from the tax professional by giving the property owner exact measurements, construction material, and costs for a roof that is this age. Easy and accurate recording is possible for disposal, retirement, and improvement of property. We now need to examine the details.

We would like to be able to show which cases would be subject to recapture and where it would apply, as well as how likely it would reduce the return of tax benefits that the owner would have received. It is a good idea to begin by listing the types of property owners that could be subject to recapture. Five elements are required. All five must be present to trigger recapture, or be substantial enough to deter others. An investor is someone who purchases Investment Property.

1.  The current year
2.  Is there a large tax liability for the current year?
3.  Uses the 179/Bonus Depreciation in conjunction with a Cost Segregation Study.
4. The property is sold within 10 years.
5. It is not possible to exchange a 1031 property for another.
6. We will discuss each element and explain why they are important in the next paragraph.

1. Why Is It Important To Buy The Property In The Current Year?

First, a cost segregation analysis categorizes 1250 property as 1245 property. This is when the term “allowed/allowable” becomes relevant. The 200DB or double declining deductions are allowed for property that was 1250 in value and now has a 5-year property of 1245. Double declining (or 150 declining in the case of 15-year property) is designed to accelerate depreciation in the early years while slowing down in the latter. It is not accidental that depreciation is falling at such an alarming rate. Assets less than 20 years in length lose resale values much faster than straight lines in the beginning and then level off towards the end. Consider the loss of value when you take a new car off the lot. Let’s take an example of a $100,000 five-year property that was purchased three years back. The properties allowed or allowable remaining value is only $28,800. An asset that is replaced every five years has a lower resale price than one that is replaced every three years. Let’s assume the asset is purchased for $30,000. The difference between the sale price of the asset and $28,800 would be the amount subject to recapture. This amounts to $200 of tax or $80 in recapture. In this case, the $30,000 total recapture would apply if a 179/Bonus vote was made. However, this is only if $30,000 was used. We will discuss this further.

The “catch-up” provision that is associated with cost segregation is another topic that can cause confusion. The cost segregation study alters the property. In this example, $7,692.30 is used ($100,000/39-years X 3-yrs). This calculation then reconciles with $71,200 that would have been depreciated in cost segregation. The property owners get a $63,507.69 current deduction. While this doesn’t result in recapture, it does stop the taxpayer from having to pay double taxation. They will be able to catch up to the IRS-approved amount.

2. It is important that the current tax liability is high.

You will notice a nice clause that adds back any unutilized 179 depreciation when you go into the calculation for recapture. This provision makes it possible that the unused bonus of 179 could be captured by the double declining balance in a matter of years. Let’s take the previous example. Let’s say $100,000 5-year property receives 179 bonus. $70,000 of the bonus will be used within the first three years. This is how it works: $70,000 bonus + Unused bonus 179 or $71,200 — $100,000 + $30,000 = $1,200. This positive number indicates that recapture is unlikely in any significant way.

3. Is Cost Segregation possible without the 179 bonus?

It is unlikely, the simple answer. Recapture calculations almost always start with the bonus amount depreciated. Selecting 100% bonus is the best way to make the depreciation schedule far ahead of the property’s resale price. The depreciation schedule for 5-year property cannot be used without a bonus. It is meant to be as close as possible to the 5-year property’s actual value. It is not possible to change a 1250 property which has been depreciated for 39 years to a 1245 property which has been depreciated for 5 years. This may seem like one to the property owner, but it is not according to the IRS definition. There are many provisions in the IRS codes that allow one person to add or subtract tax liability from another. The IRS codes provide many provisions that allow taxpayers to change from the composite form depreciation to one of its component forms. However, this does not guarantee a tax bonus.

4. What is the best way to trigger recapture?

There are many reasons an asset may be removed from the balance sheet. Business owners have three options: retirement, disposal, or a sale. Recapture can only be triggered by a sale. Only sales exceeding the amount depreciated are eligible. Recapture can be affected by retirement or disposal, as we have discussed. A sale is the only thing that can trigger recapture. The assets that are 1245 property have a value that is not equal to their actual value. It is sensible to follow government guidance and assign a value for the asset that corresponds to the MACRS schedule. The decision to sell or not is another strategy that has eluded us. We assumed the property would be sold throughout this paper, but we did not realize that it was possible. Many times, property owners decide to keep their property after learning how cost segregation can benefit them.

5. Can you do a 1031 exchange after a cost segregation?

Although the process of transferring Real Estate Property like-to-like can be more difficult when you have to deal with cost segregated properties, the potential benefits could be well worth it. It is a common saying that “accelerated depreciation works best when repeated.” Property owners can defer taxes for long periods by performing cost segregations. They could then exchange larger, more costly properties and then perform another cost segregation on their new property. This technique is used to process a 1031 exchange. The 1031 is an asset transfer that occurs in a similar way to the original. Cost segregation transforms one type of property (39-year) into four different types. Property that was allocated to 5-year or 7-year terms, 15-year or 39-year periods must be transferred to a new property with a cost segregation. The new property must have equal or greater allocations to each property. It may be beneficial to transfer a substantial portion of the sale to the 1250 property, and 1031 to that amount, if the property has been in the same place for more than ten years.

We will list the annual depreciation deductions for this strategy, while adding $1,000,000 every seven year to make it less complicated. These numbers are huge in comparison to the potential income that $4,000,000 worth of property could generate. We had to assume certain things, simplify the transaction costs and not account all variables. The goal is not to argue that asset recapture is positive cash flow. This post aims to demonstrate how few cases could be subject to significant recapture taxes.