Tax Strategy

Depreciation Strategies: The Tax-Free Cash Flow Secret

Paper Losses, Real Tax Savings

Real estate depreciation creates tax-free cash flow through paper losses. Learn standard schedules, basis allocation, and how to avoid recapture through 1031 and stepped-up basis.

Schedule a Strategy Session Explore Calculators

27.5 Years

Residential Property Depreciation

39 Years

Commercial Property Depreciation

25%

Depreciation Recapture Tax Rate

Cash Required for Depreciation Deduction

Quick Answer

Depreciation creates tax-free cash flow by reducing taxable income without reducing actual cash received
Residential property depreciates over 27.5 years; commercial over 39 years; improvements may qualify for faster schedules
Leverage amplifies depreciation benefits - you depreciate the full property value, not just your equity
1031 exchange defers depreciation recapture indefinitely; stepped-up basis at death eliminates it
Maximize depreciable basis through proper allocation - minimize land value, maximize building and improvements

The Opportunity

Why Depreciation Matters

Tax-Free Cash Flow Through Paper Losses

Depreciation is a non-cash expense that reduces taxable income without reducing actual cash flow. A property generating $50K cash flow might show $0 or negative taxable income after depreciation. You keep the cash while paying little or no tax on it. This is the core of real estate tax advantage.

Standard Depreciation Schedules

Residential rental property: 27.5-year straight-line depreciation. Commercial property: 39-year straight-line. Land is not depreciable. Improvements, furniture, appliances, and certain components follow shorter schedules (5, 7, 15 years). Understanding schedules helps optimize your depreciation strategy.

Depreciation Stacking with Leverage

Depreciation applies to the full property value, not just your equity. Buy a $1M property with $200K down, and you depreciate the full $1M building value (minus land). This leverage amplifies depreciation benefits relative to your investment. More depreciation per dollar invested.

Deferred Tax, Not Eliminated Tax (Usually)

Depreciation reduces basis, so eventual sale creates larger gain subject to depreciation recapture (25% rate). However, 1031 exchange defers recapture indefinitely. At death, stepped-up basis eliminates all deferred tax. Strategic investors often never pay the recapture through proper planning.

Implementation

Proven Strategies

Maximize Depreciable Basis Allocation

When purchasing property, allocate purchase price to maximize depreciable assets. Land is not depreciable, but building, improvements, and personal property are. A proper allocation supported by appraisal can increase depreciable basis by 10-20%. Every dollar allocated to depreciable property generates tax savings.

Best for: All real estate investors at acquisition to establish maximum depreciable basis from day one.

Example:

$1M purchase. Without strategy: $300K land, $700K building (39-year). With proper allocation: $200K land, $700K building, $100K site improvements (15-year). Higher depreciable basis + faster depreciation on improvements = larger deductions.

Bonus Depreciation on Qualified Improvement Property

Qualified Improvement Property (QIP) - interior improvements to non-residential buildings - qualifies for 15-year depreciation and bonus depreciation (60% in 2024). Any interior renovation to commercial space (excluding structural components, elevators, enlargements) can generate massive first-year deductions.

Best for: Commercial property owners making interior improvements to existing buildings.

Example:

$200K tenant improvement to office building. Standard 39-year: $5.1K annual depreciation. As QIP with 60% bonus depreciation: $120K year-one deduction + $80K over 15 years. Immediate tax savings: $44K (at 37% rate) vs $1.9K.

Strategic Depreciation with 1031 Exchange Planning

Use depreciation aggressively knowing you will 1031 exchange rather than sell outright. Maximize bonus depreciation and cost segregation benefits. When ready to exit, exchange into replacement property, deferring all depreciation recapture. Continue the cycle indefinitely, then eliminate at death through stepped-up basis.

Best for: Long-term real estate investors who will hold or exchange properties rather than sell outright.

Example:

Take $500K accelerated depreciation over 10 years. Potential recapture at sale: $125K (25% rate). Instead of selling, 1031 exchange - $0 recapture. Continue depreciation on new property. At death: heirs inherit at stepped-up basis. $500K depreciation taken, $0 ever recaptured.

Avoid These Pitfalls

Common Mistakes

Over-Allocating to Land

Many investors use arbitrary allocations (e.g., 20% land) without analysis. In some markets, land is 40%+ of value; in others, 10-15%. Get an appraisal or use tax assessor allocations to support your position. Over-allocating to land leaves depreciation deductions on the table.

Ignoring Depreciation When Passive

For passive investors, depreciation creates passive losses that may be suspended if you have no passive income to offset. However, these losses carry forward and can offset future passive income or be released when you sell. Plan depreciation strategy around your passive activity status.

Forgetting to Depreciate Improvements Separately

Capital improvements (roof, HVAC, parking lot) should be depreciated separately from the original building. New improvements reset the depreciation clock with potentially shorter lives. Failing to track improvements separately means slower depreciation than you are entitled to.

Questions

Common Questions

Here are the most common questions we receive about this topic.

Ask Your Question

Depreciation is a paper expense that reduces taxable income without reducing cash. Example: Property generates $60K cash flow. After $40K depreciation expense, taxable income is $20K. You pay tax on $20K but keep $60K cash. As depreciation increases relative to cash flow, effective tax rate on cash flow decreases - potentially to zero.

When you sell depreciated property, previously claimed depreciation is recaptured and taxed at 25% (Section 1250) or ordinary rates (Section 1245). Avoidance strategies: (1) 1031 exchange defers all recapture, (2) Hold until death - heirs receive stepped-up basis eliminating recapture, (3) Installment sale spreads recapture over time.

Only the rental portion. If you rent a property 9 months and live there 3 months, you can depreciate 75% of the property. Short-term rental rules are complex - if average rental period is 7 days or less, you may qualify for different treatment. Personal use days affect depreciation eligibility.

Depreciation flows through to partners/investors proportionally based on ownership and partnership agreement allocations. K-1 reports your share of depreciation. Passive activity rules still apply - depreciation from passive investments creates passive losses that may be suspended for non-Real Estate Professionals.

Usually yes, due to time value of money. Tax saved today can be invested and compound for years. Recapture at sale is at 25% - often lower than ordinary rates. Most importantly, 1031 exchange and stepped-up basis at death can eliminate recapture entirely. Aggressive depreciation with proper exit planning is optimal for most investors.

Ready to Optimize Your Depreciation Strategy?

Depreciation is the foundation of real estate tax benefits. Let us help you maximize deductions, plan for recapture avoidance, and create truly tax-advantaged cash flow.

Schedule Your Strategy Session Explore Related Strategies