Section 1245 Recapture in a 1031 Exchange: Why a Cost-Segged Building Can Owe Tax With No Boot

The trap in one sentence

A like-kind exchange defers gain, but Section 1245 has its own rule for exchanges, and it overrides the general deferral: the ordinary recapture you owe on the old property's personal-property components is limited only to the gain you recognize plus the fair market value of property you receive that is not Section 1245 property (IRC 1245(b)(4)). If you hand over cost-segged carpet, cabinetry and dedicated electrical, and get back mostly building shell and land, the regulation treats you as having traded 1245 property for non-1245 property. That difference is ordinary income in the exchange year, even when the qualified intermediary reports zero boot.

Before cost segregation and bonus depreciation were common, this rarely mattered, because most buildings carried little 1245 depreciation. A study that moved 20% or 30% of a building into 5- and 7-year lives, written off at 100% bonus for property acquired after January 19, 2025 (P.L. 119-21 section 70301; IRS Notice 2026-11) or at the phase-down rates for earlier years, changes that.

How the limit is computed

Start with what would be recaptured in a taxable sale. For each 1245 component, recapture is the lesser of the depreciation taken on it or the gain on it (IRC 1245(a)(1)). Then apply the exchange limit (Treas. Reg. 1.1245-4(d)(1)):

1. Gain recognized on the exchange anyway (boot), plus
2. The fair market value of non-1245 property you receive that was not already counted as boot.

Recapture is the smaller of the sale amount or that limit. In a typical real estate exchange the replacement building and land are worth far more than the old components, so item 2 is large and the practical question becomes how much of the components' value comes back to you as Section 1245 property. The regulation's examples match 1245 property received against 1245 property given up; when the replacement is short, the shortfall is recaptured.

Real structural components are a separate question. For Section 1031, structural components of a building are real property even if a study treats some of them as 1245 property for depreciation (Treas. Reg. 1.1031(a)-3(a)(2)). Movable personal property is not like-kind real property at all, so value you receive in that form is taxable. Your qualified intermediary and attorney should confirm which items fall where.

Worked example: zero boot, real tax

Our couple sells an office building in Texas that was cost-segged in 2021. The 5- and 7-year components were fully written off and are worth $250,000 at the exchange, so a cash sale would recapture $250,000 (the per-component cap holds it below the larger amount of depreciation taken). They roll every dollar into a replacement that, without a study, carries only $50,000 of Section 1245 property.

The $200,000 shortfall is ordinary income: $56,740 of 2026 federal tax and net investment income tax, with $7,600 of that being the 3.8% tax (IRC 1411, threshold $250,000 joint, not indexed, 2026). In California the same shortfall costs $75,340, of which $18,600 is state tax. If a study on the replacement documents $200,000 of 5- and 7-year property before the return is filed, the shortfall drops to $50,000 and the tax to $13,900, a difference of $42,840. Numbers are illustrative engine output from labeled assumptions; the matching of specific components is your CPA's call.

The per-component cap: value the old components honestly

The recapture exposure is not the depreciation you took. It is capped, component by component, by the gain on that component, which depends on its value at the exchange (IRC 1245(a)(1)). Five-year carpet that was installed seven years ago may be worth very little. A defensible, documented low value for worn 5- and 7-year items shrinks the amount that needs matching 1245 property on the other side.

• Get the valuation in writing from an appraiser or the engineer who did the original study, as of the exchange date.
• Be consistent. The value you use for recapture should match what the exchange documents and any allocation say. A buyer of your old building may want a high personal property value for its own bonus depreciation; that pushes your recapture up. See purchase price allocation.
• Land improvements such as parking lots and landscaping are 1250 property. Bonus on them is additional depreciation recaptured under IRC 1250(a), with a separate exchange limit in IRC 1250(d)(4) that looks at 1250 property received. Swapping into another building usually covers it, but check.

How to plan the replacement side

Most of this is fixed before closing on the replacement, not at tax time.

• Order a study or a desktop estimate on the replacement during due diligence, so you know whether it carries enough 1245 property. Retail, hospitality, medical office and multifamily with modern finishes tend to carry more than raw land, warehouses with little build-out or a ground lease.
• Delaware statutory trust interests as replacement property: ask the sponsor for its cost segregation figures. Many sponsors commission studies, but the 1245 share varies by asset.
• Do not count on bonus on the replacement to fix it. Bonus on used replacement property applies only to excess basis (Treas. Reg. 1.168(k)-2(g)(5)(iii)(A)); the recapture limit looks at the value of 1245 property received, not at the bonus you can claim. The two questions are separate. See cost segregation after a 1031 with boot for the depreciation side.
• Trading into land only (farmland, raw land) nearly always produces a full shortfall on any cost-segged components.

When the recapture also hits an installment sale or a carryback

If you skip the exchange and sell with seller financing, the full recapture lands in year one regardless of how little cash you collect: recapture income is recognized in the year of disposition under IRC 453(i), and only the rest of the gain is spread. A cost-segged property sold on a note can leave the seller paying tax out of pocket in the year of sale unless the down payment covers it. Size the cash at closing to the recapture tax first. See recapture in an installment sale.

The same logic applies to a 1031 with a buyer's note as part of the price: the note is boot, and any recapture that 1245(b)(4) does not shelter comes out in the exchange year.

Questions to ask before you sign

1. Was the property you are selling ever cost-segged, or did you take bonus or Section 179 on any of it? (your CPA)
2. What is each 5- and 7-year component worth today, in writing? (appraiser or engineer)
3. How much Section 1245 property does the replacement carry? (engineer, or the sponsor for a Delaware statutory trust)
4. Does the contract or exchange agreement state an allocation between real and personal property? (attorney)
5. Which items are personal property, not like-kind real property, under Treas. Reg. 1.1031(a)-3? (qualified intermediary, attorney)

Get the Big Sale Tax Analysis to model the recapture in a 1031, a cash sale and an installment sale side by side.

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