Your Exit Tax Bill Is Bigger Than You Think

Most operators model the whole gain at 15 to 20 percent and move on. That number feels right. You've held the deal long enough to qualify for long-term capital gains treatment, you've been a good tax-planning citizen, and your accountant ran the numbers at closing. Fifteen percent. Maybe twenty. You've planned accordingly.

The problem is that model is wrong, and the gap between that number and your actual tax bill at closing can be six figures.

Here's what's actually happening inside a sale.

The IRS doesn't see one gain when you sell a property. It sees two, with different rates running underneath each. Each piece carries a different tax treatment, and they don't all look like capital gains. Understanding how the gain gets split is the only way to model your exit accurately. Most operators skip this entirely.

The First Piece: Ordinary-Rate Depreciation Recapture Under §1245

If you did a cost segregation study on the property, you likely accelerated a significant portion of the depreciation into year one. That's the whole point. Front-load the deductions, shelter current-year income, reduce the tax drag on cash flow. It works exactly as advertised.

What most operators don't model is what happens to that depreciation on the back end.

The IRS treats the depreciation you claimed on the personal property components — the ones reclassified through cost seg — as §1245 recapture on the sale. The recapture is taxed at ordinary income rates, which means up to 37 percent depending on your bracket. This applies whether the depreciation came from bonus, MACRS accelerated methods, or both. Bonus depreciation isn't a separate category of recapture; it's just one of the ways the depreciation got front-loaded.

The recapture amount is the lesser of the depreciation you claimed on those components or the total gain on them. If the components sold for more than your original purchase allocation, the excess gain above original cost flows to §1231 and is treated as capital gain. But the recapture portion itself — every dollar up to your accumulated depreciation — is taxed at ordinary rates.

It doesn't matter how long you held the deal. It doesn't matter that the property itself would qualify for long-term capital gain treatment. The §1245 recapture gets taxed at your top marginal rate.

The Second Piece: Capital Gain, With a Sub-Rate Inside It

Everything else falls into capital gain treatment, but there's a wrinkle most operators miss.

The portion of your gain on the building itself that's attributable to prior straight-line depreciation — the §1250 property — gets taxed at a special 25 percent rate. This is called unrecaptured §1250 gain. It's capped at the lesser of accumulated straight-line depreciation or the total gain on the §1250 property, but for any deal held five to ten years with normal appreciation, the 25 percent rate will absorb the full depreciation amount.

On a $5 million building, you might have $900,000 or more in straight-line depreciation sitting on the books by the time you sell. Assuming sufficient gain on the §1250 component, that entire amount gets taxed at 25 percent.

The remaining gain above accumulated depreciation — the true appreciation — gets long-term capital gains treatment at 15 or 20 percent. This is the number most exit models are built around, and for many deals it's the smallest piece of the three.

There are also considerations layered on top of those headline rates that can shift your actual liability. The Net Investment Income Tax adds 3.8 percent on top of capital gains for most CRE operators at this income level. State tax adds more depending on where you live and where the property sits. Those aren't always make-or-break, but they're real, and they widen the gap between the rate you modeled and the rate you actually pay.

Here's where the math breaks down in practice.

Say you buy a property for $4 million, allocate roughly 25 percent to personal property components through cost seg, and hold it for seven years before selling for $6.5 million. You run an exit model, see a $2.5 million gain, apply a blended 20 percent rate, and model a $500,000 tax bill. Clean. Reasonable. Wrong.

Underneath that $2.5 million total gain, you have three rate streams running. You have §1245 recapture on the accelerated components taxed at ordinary rates up to 37 percent. You have accumulated straight-line depreciation on the structure taxed at 25 percent. And you have the true appreciation taxed at 15 to 20 percent, plus NIIT, plus state. Those don't average out to 20 percent. They stack in a way that can push your effective rate on the total gain well above it.

The cost segregation study that saved you meaningful tax in year one created a recapture liability that will show up at closing. That's not a design flaw in cost seg. Cost seg still works. The math on the front end is real. But the back-end recapture has to be in the model from day one, or you're underwriting a deal with incomplete information.

There are structures that address this directly, but each comes with a real limitation worth understanding.

An installment sale spreads the capital gain portion across multiple tax years, which can help with the appreciation piece. It does not help with the recapture. Under §453(i), all §1245 recapture is recognized in full in the year of sale regardless of how the payments are structured. The ordinary income hit accelerates to year one whether you want it to or not.

A 1031 exchange defers the gain entirely, including the recapture, but doesn't eliminate it. The deferred recapture liability migrates into the replacement property's basis and resurfaces on a future sale unless you exchange again.

None of those tools work if you don't know the problem exists before you sign a purchase and sale agreement. Certain structures require advance planning, sometimes years in advance. By the time you're in due diligence, several of your options are already gone.

The depreciation you took on day one is still on the table the day you sell. The IRS never forgets which deductions you claimed, and the recapture clock starts running the moment you file that first return.