When commercial real estate is sold at a gain, not all of that gain is taxed at the preferential long-term capital gains rate. Section 1250 of the Internal Revenue Code requires that the portion of gain attributable to prior depreciation deductions be taxed at a higher rate, reflecting the policy judgment that deductions taken against ordinary income during the holding period should not convert to capital gain on disposition. For real property subject to straight-line MACRS depreciation — the standard for 39-year nonresidential real property — the accumulated depreciation is classified as unrecaptured Section 1250 gain and is taxed at a maximum federal rate of 25%, compared to the 20% maximum rate applied to other long-term capital gains. The 3.8% Net Investment Income Tax applies on top of both rates for high-income taxpayers.
The mechanics on a simple example: a commercial building purchased for $5 million is depreciated at $128,205 per year (1/39th) over 10 years, producing $1,282,050 of accumulated depreciation. The adjusted basis at sale is $5,000,000 minus $1,282,050, or $3,717,950. If the building sells for $6,500,000, the total gain is $2,782,050. Of that gain, $1,282,050 is unrecaptured Section 1250 gain taxed at up to 25%, and the remaining $1,500,000 is long-term capital gain taxed at up to 20%. Plus NIIT on both layers. The blended effective federal rate on this transaction for a taxpayer in the highest bracket can approach 30% before state income taxes, meaningfully higher than the headline 20% capital gains rate most investors cite when thinking about real estate tax.
Cost segregation studies interact directly with Section 1250 recapture in ways that every cost segregation analysis should model explicitly. A cost segregation study that reclassifies $1 million of the purchase price from 39-year property to 5-year personal property generates substantially accelerated depreciation — the entire $1 million may be deducted in the first year through bonus depreciation. But upon sale, that $1 million of personal property depreciation is subject to Section 1245 recapture at full ordinary income rates (not the capped 25% Section 1250 rate), and the remaining real property depreciation is subject to unrecaptured Section 1250 gain at 25%. The front-loaded deductions from cost segregation are real and valuable on a present-value basis, but the seller faces a larger and more complex recapture calculation at disposition that must be modeled against realistic holding period and tax rate assumptions before the cost segregation study is commissioned.
The 1031 like-kind exchange defers Section 1250 recapture by deferring recognition of the entire gain — the unrecaptured depreciation carries forward into the replacement property's basis and remains deferred until the replacement property is eventually sold in a taxable transaction. This is one of the primary motivations for 1031 exchanges on fully or heavily depreciated commercial properties: selling outright can produce a very large recapture tax bill that the exchange permanently defers for reinvesting owners. Taxpayers who plan to hold real estate until death benefit from the step-up in basis — the property's tax basis resets to fair market value at the date of death, permanently eliminating both the accumulated capital gain and all of the unrecaptured Section 1250 gain that had been deferred through holding or 1031 exchanges. Estate planning for CRE portfolios frequently centers on this step-up benefit for properties with large embedded depreciation.
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