How to Use Depreciation for Tax Savings

Depreciation is one of the most powerful tax benefits available to real estate investors. While your property might be increasing in value, the IRS allows you to take deductions for its wear and tear, significantly reducing your taxable income. In this podcast episode, we explore how depreciation works, different methods for maximizing deductions, and strategies to mitigate depreciation recapture.

Understanding Depreciation

Depreciation is a non-cash expense that real estate investors can claim to offset income. It’s based on the principle that buildings deteriorate over time, even if their market value increases.

The IRS allows property owners to deduct a portion of their property’s cost annually based on its classification:

• Residential properties: Depreciated over 27.5 years.
• Commercial properties: Depreciated over 39 years.
• Land improvements: Depreciated over 15 years.
• Appliances and personal property: Depreciated over 5 to 7 years.

Because depreciation is a paper expense, it reduces taxable income without affecting cash flow, making it a critical tax-saving tool.

Straight-Line vs. Accelerated Depreciation

There are two primary methods for calculating depreciation:

1. Straight-line depreciation – Spreads deductions evenly over the asset’s useful life (e.g., 27.5 years for residential property).
2. Accelerated depreciation – Allows for larger deductions earlier in ownership by using methods like:
   • Double declining balance
   • Bonus depreciation (allows immediate deduction of a large percentage in the first year)

Bonus Depreciation Trends

Bonus depreciation has changed over time, providing significant tax benefits to investors:

• 2018-2022: 100% bonus depreciation was available.
• 2023: 80% bonus depreciation.
• 2024: 60% bonus depreciation.
• 2025: 40% bonus depreciation (subject to legislative changes).

Investors should take advantage of these deductions while they last to maximize upfront tax savings.

Using Cost Segregation Studies

A cost segregation study is an analysis that breaks down property components into categories eligible for faster depreciation schedules. This allows investors to shift components such as flooring, cabinetry, and HVAC systems from 27.5- or 39-year schedules into shorter ones, enabling larger deductions in the early years of ownership.

Cost segregation studies are particularly useful when:

• You qualify for Real Estate Professional Status (REPS).
• You utilize the Short-Term Rental Loophole.
• You plan to sell a property and need to offset gains with depreciation.
• You have significant passive income from rental activities.

The “Lazy 1031 Exchange” Strategy

A 1031 exchange allows investors to defer capital gains taxes when selling a property and reinvesting in another. However, for those who want an alternative, the “Lazy 1031 Exchange” provides another option: investors can purchase another property within the same tax year and use the depreciation from the new purchase to offset the gains from the sale of an existing property.

Passive vs. Non-Passive Losses

Depreciation can generate losses that are classified as either:

• Passive losses: Offset rental income and other passive gains.
• Non-passive losses: Offset W-2 income or business income (available for those qualifying for REPS or using the STR loophole).

Understanding these classifications is crucial for optimizing tax benefits.

Depreciation Recapture: The “Dark Side”

While depreciation offers substantial tax savings, there’s a catch when selling a property: depreciation recapture tax.

When a property is sold, the IRS requires investors to “recapture” the depreciation claimed over the years, meaning a portion of the gain may be taxed at a higher rate.

• Section 1245 property (accelerated depreciation on personal property) is taxed at ordinary income tax rates (up to 37%).
• Section 1250 property (accelerated depreciation on land improvements) is taxed at ordinary income tax rates.
• Straight-line depreciation recapture is capped at 25%.

To avoid or defer these taxes, investors can use strategies like 1031 exchanges or the Lazy 1031 Exchange.

The 1031 Exchange: Deferring Depreciation Recapture

A 1031 exchange is a tax strategy that allows investors to roll over gains from a property sale into a new investment property, deferring capital gains and depreciation recapture taxes.
A long-term strategy is to keep utilizing 1031 exchanges throughout your lifetime. Upon death, heirs receive a step-up in basis, eliminating deferred taxes altogether.

Key Takeaways & Next Steps

1. Depreciation is a powerful, non-cash deduction that reduces taxable income.
2. Accelerated depreciation and cost segregation studies help investors maximize deductions earlier.
3. 1031 exchanges and strategic planning can defer or eliminate depreciation recapture.
4. Time-sensitive tax benefits like bonus depreciation should be leveraged while available.

If you need help implementing these strategies, contact us at contact@therealestatecpa.com or join our TaxSmart Investors Facebook group.

By strategically utilizing depreciation, investors can significantly lower their tax liability while growing their real estate portfolios. Stay informed, stay strategic, and keep building wealth through real estate!

Thanks for reading, and we’ll catch you on the next episode of the TaxSmart REI Podcast!

Want personalized tax strategy related to your portfolio? Schedule a consultation with our team.

Transcript

Introduction

Thomas Castelli, CPA (00:00.898)
Hey, welcome to this week’s episode of the TaxSmart REI. Today, we’re gonna be doing a depreciation deep dive. We know depreciation is everybody’s favorite topic, because it’s such a tax savings tool. So we’re gonna talk about cost segregation studies, what depreciation is, how it works, depreciation recapture, how to avoid it, and so much more. If you’re interested in reducing your taxes by using real estate, this episode’s for you. We’ll be diving into all of that in just one minute.

All right, we’re back, and Ryan, today we’re talking about everybody’s favorite topic: depreciation—what it is, how it works, strategies, the whole nine. If you’re new to the show, this is going to be an eye-opener for you. If you’re a long-time listener, it’s going to be a great refresher. You’ll probably learn some new things or be reminded of some concepts you already know. Let’s start with the basics: what is depreciation, and why are we even talking about it on today’s episode?

Ryan, do you mind taking it away and explaining exactly what depreciation is?

Defining Depreciation

Ryan Carriere, CPA (01:01.169)

Yeah, depreciation conceptually would be, like, an expense related to the deterioration of a physical asset over time. If you buy a building for $500,000, over time it’s going to start to deteriorate physically, because that’s just what happens with tangible assets. So, in a hundred years, it’s likely not going to be the exact same material or condition you originally bought. Our lawmakers basically said, ‘You can get this depreciation deduction because these things slowly deteriorate.’ That’s the idea.

It’s really a capital asset that we’re deducting the cost of over time. For example, we have 27.5-year property (residential), 39-year property (commercial), 15-year property (land improvements), and then five- or seven-year property for certain items. These timelines are set based on how quickly things are expected to wear out. It’s also a non-cash expense. We did pay for the building up front, but the ongoing depreciation expense each year doesn’t involve another outlay of cash. So it’s a non-cash write-off that we get to take advantage of over the property’s life.

That’s the high-level overview. Did I miss anything, Tom?

Why Depreciation Matters

Thomas Castelli, CPA (02:47.051)

No, you did great. A quick recap for anyone new: Depreciation tracks the ‘wear and tear’ on a property over time, even if that property is actually appreciating in value on the market. It’s a non-cash expense that lowers your taxable income without reducing your actual cash flow—hugely powerful for real estate investors.

We typically combine it with strategies like the Real Estate Professional Status or the Short-Term Rental Loophole to maximize tax savings. It’s a big piece of the puzzle for reducing taxes when investing in real estate. Now, as you mentioned, there are different types of depreciation—straight-line and accelerated. Straight-line is pretty simple…

Straight-Line vs. Accelerated Depreciation

Thomas Castelli, CPA (03:47.726)

Straight-line depreciation is, as it sounds, a straight line. For a residential property, you depreciate it over 27.5 years. For commercial property—retail, office, industrial—it’s 39 years. You do need to exclude land value, because land itself never gets depreciated.

For example, if you have a residential property with a building value (excluding land) of $275,000, you’d divide that over 27.5 years, which comes out to $10,000 of depreciation per year. For commercial, if the building portion was $390,000, that’s $10,000 per year over 39 years.

Then there’s accelerated depreciation, which involves shorter lifespans (like five-year, seven-year, or 15-year property) and methods like the double declining balance. This was super popular when we had 100% bonus depreciation. Now with bonus depreciation percentages phasing down, some people are using double declining balances more often. But the gist is it lets you front-load more depreciation in the earlier years.

Bonus Depreciation

Thomas Castelli, CPA (06:04.493)

Bonus depreciation has been incredibly potent for a while. From 2018 to 2022, you could take 100% bonus depreciation on those five-, seven-, and 15-year assets. But it’s since started phasing down—80% in 2023, 60% in 2024, 40% in 2025, and so on. Some of us think 100% might come back under a new administration, but we’ll have to see.

How do you figure out which parts of your building qualify for five- or 15-year depreciation? You get a cost segregation study. They come in, examine your property, and break down all the components into the different depreciation schedules.

Connecting Cost Segregation and Bonus Depreciation

Ryan Carriere, CPA (08:40.23)

I want to clarify a few terms people hear: accelerated depreciation, bonus depreciation, cost seg. A cost segregation study determines which parts of your purchase fall into the five-, seven-, 15-, or 27.5-year buckets. Anything under 20 years is eligible for bonus depreciation. So the cost seg shows you the proportions, and then bonus depreciation is essentially the ‘how fast?’—like 100%, 80%, etc. They work hand in hand.

Now, should you do a cost segregation study? It depends on whether you can use those losses right away. Do you have passive or non-passive losses? If it’s non-passive because of real estate professional status or the short-term rental strategy, the cost seg is super valuable. If it’s passive, it might still be useful, especially if you have passive gains from another property sale.

The “Lazy 1031 Exchange”

Ryan Carriere, CPA (11:07.44)

Speaking of passive gains—if you sell a rental property for a gain, that’s passive income. But you can offset it with passive losses from another property—losses generated by accelerating depreciation through cost segregation, even if you’re not a real estate professional. That’s sometimes called the “lazy 1031 exchange” because you’re not actually doing a 1031, but you’re using passive losses to offset a passive gain.

Passive vs. Non-Passive Losses

Thomas Castelli, CPA (12:47.723)

Right, and a quick note for clarity: When people say, ‘Can depreciation offset my W-2 income?’—technically, the depreciation creates a loss, and it’s that loss that offsets your W-2, but only if it’s non-passive (e.g., you qualify for real estate professional status or the short-term rental loophole). If it’s passive, you can still offset your passive gains or rental income.

So you have to determine if your losses are passive or non-passive. Cost seg can help in both scenarios, but the strategies differ.

Timing and Suspended Losses

Ryan Carriere, CPA (15:13.958)

I’ve been passive for a while and accumulated losses that are suspended. I’ll likely sell some properties, and that will “unlock” these suspended losses. I couldn’t use them before because I was passive, but they’re still there. If I can trigger them in the same year I have a passive gain, I can offset that gain. It’s all about timing.

Depreciation Recapture: The “Dark Side”

Thomas Castelli, CPA (17:12.717)

Now, the flip side: when you claim depreciation, you reduce your basis in the property each year. When you sell, you face depreciation recapture. If, for example, you bought a property at $500,000, took $200,000 in depreciation, your basis is now $300,000. Selling at $800,000 creates a $500,000 gain ($300k basis to $800k sale price). Of that, $300k is capital gain, and $200k is subject to depreciation recapture.

Recapture rates vary: Section 1245 (five-year property) is taxed at ordinary rates (up to 37%). Section 1250 (accelerated depreciation on land improvements) is also at ordinary rates. Straight-line depreciation recapture is capped at 25%.

People ask, ‘Why accelerate depreciation if I have to pay it back?’ First, the IRS assumes you took it anyway, so you can’t opt-out. Second, by taking more deductions now, you get the benefit of the time value of money. And third, you can mitigate recapture through a 1031 exchange, continually rolling properties over, and eventually, your heirs receive a step-up in basis.

Should You Do a Cost Segregation Study if You Plan to Sell Soon?

Ryan Carriere, CPA (22:37.564)

Whether it’s worth doing a cost seg can depend on your hold period. If you’re only keeping a property for a year and not doing a 1031, it might not be worth it. But if you plan to upgrade properties, have good equity, or see yourself holding real estate for the long haul, it can be very beneficial. Just make sure you understand the long-term plan so you’re not surprised by recapture.

Recap and Final Thoughts

Thomas Castelli, CPA (25:14.369)

Let’s wrap up with a summary:

1. Depreciation is a powerful non-cash expense that can create paper losses, lowering taxable income without hurting your cash flow.
2. Straight-line depreciation covers 27.5 or 39 years for the building.
3. Accelerated depreciation uses five-, seven-, or 15-year schedules (identified via cost segregation).
4. Bonus depreciation lets you claim a large portion of those shorter-life assets upfront, subject to the current percentage phase-down.
5. Depreciation recapture is the tax you pay on the depreciation you claimed, but strategic moves like 1031 exchanges or the “lazy 1031” can mitigate it.
6. Real Estate Professional Status and Short-Term Rental Loophole can turn rental losses into non-passive, offsetting W-2 or business income. Otherwise, you still have powerful uses for passive losses.*

If you have questions, email us at contact@therealestatecpa.com or join our Facebook group, TaxSmart Investors. If you want expert guidance, request an initial consultation at www.therealestatecpa.com/podcast. Thanks for tuning in, and we’ll catch you on next week’s episode of the TaxSmart REI Podcast!

Disclaimer: This podcast summary and transcript were partly generated and may contain some errors or miss key points from the audio recording.