Hypothetical: Sale and Recapture After a Study

This example compares two versions of the same property at sale to show the direction of the effect.

The facts assumed

A hypothetical owner buys a building for $500,000, with $100,000 land and $400,000 depreciable. The owner sells five years later for $600,000. Selling costs are ignored for simplicity.

Version A: no study

The $400,000 is depreciated over 27.5 years straight line, about $14,500 a year. After five years, roughly $70,000 of depreciation is taken. Adjusted basis is about $430,000. Gain is $170,000. Of that, $70,000 is depreciation-related on real property, and $100,000 is appreciation. In this hypothetical, the $70,000 is treated as unrecaptured Section 1250 gain at an assumed maximum rate of 25 percent, and the $100,000 at an assumed 20 percent.

Assumed tax: 25 percent of $70,000 is $17,500, and 20 percent of $100,000 is $20,000. Total $37,500.

Version B: with a study

Assume a study shifts $80,000 into short-lived classes and, with bonus assumed available, that entire amount is deducted in year one. The remaining $320,000 building is depreciated at about $11,600 a year, or about $58,000 over five years. Total depreciation over five years is $138,000. Adjusted basis is $362,000. Gain is $238,000.

Now suppose the allocation of the sale price to the short-lived items is $25,000, so that gain on those items is $25,000, which is less than the $80,000 of depreciation taken. This gain is ordinary income up to depreciation taken. The remaining gain is on the building: $238,000 minus $25,000 gives $213,000 of gain. Of that, $58,000 is unrecaptured Section 1250 gain, and $155,000 is appreciation. Use assumed rates of 37 percent ordinary, 25 percent, and 20 percent.

Assumed tax: 37 percent of $25,000 is $9,250, 25 percent of $58,000 is $14,500, and 20 percent of $155,000 is $31,000. Total $54,750.

Comparing the two

Version B has a higher tax at sale by about $17,250 in this hypothetical, because more gain arises from lower basis and part is taxed at higher rates. That is the recapture side of the trade.

The other side

In Version B, the owner received an extra deduction of about $80,000 in year one, less what the baseline would have taken on it over five years (about $11,600). The extra early deduction is roughly $68,000 more in the early years. At an assumed 35 percent rate on the income offset, that would be about $24,000 of earlier tax savings. Subtract the study fee, for example $4,000. Net earlier savings about $20,000, against $17,250 of additional tax at sale five years later. In this hypothetical the outcome is close to break-even before considering the time value of the earlier savings and the added costs.

What varies the result

Lessons

The example is not a claim that studies do or do not pay off. It shows that the answer is the difference between two streams and depends on rates and time. See Hold Period and the Decision.

Variations to try

Extend the hold to fifteen years and see how the earlier savings look in present value terms. Assume an exchange and see how the additional tax is deferred. Change the allocation of price to short-lived items to $10,000 or $60,000. Assume lower ordinary rates at sale than at deduction. Assume the net investment income tax applies. Each variation shows why the answer moves.

Questions the example raises

What rates apply in the sale year? What would the buyer pay for the personal property? Is an exchange feasible? Would suspended losses be released? What are the state effects? Ask your preparer for a projection before listing.

What the example leaves out

Selling costs, state tax, the net investment income tax, installment sale rules, and the time value of money are ignored or only touched on. A real computation would include them.

Reading the comparison correctly

The example shows a difference of about $17,250 of additional tax at sale and about $20,000 of net earlier savings, after the fee. It might be tempting to conclude that the study is barely worthwhile. That conclusion would be premature, because the example ignores the time between the two events. Money saved in year one and taxes paid in year five are not equal in value if the owner can use the earlier savings productively. It also ignores the possibility that the owner holds longer, exchanges, or has a lower rate at sale. Conversely, it ignores state taxes and other taxes that could make the sale-year cost higher. A responsible analysis includes each.

Building your own version

Use a spreadsheet with columns for year, deduction with study, deduction without, tax effect, and sale effect. Fill in the rates you verify with your preparer. Change the sale year and see how the net changes. That simple model is often more instructive than any single figure.

Next steps

Read Section 1031 Exchanges and Depreciation Recapture and Net Investment Income Tax and Depreciation.