One of the most powerful — and misunderstood — benefits of real estate investing is depreciation. Unlike most asset classes, real estate allows investors to claim a non-cash tax deduction against real cash flow. When structured properly, accelerated depreciation has the potential to significantly increase any after-tax income in the early years of ownership.
This applies across:
Residential rental properties
Commercial real estate
Delaware Statutory Trusts (DSTs)
But while the strategy can be powerful, it is not without trade-offs.
Below is a practical overview with side-by-side comparisons and a “what can go wrong” section
Under MACRS (Modified Accelerated Cost Recovery System):
Residential rental property → 27.5 years (straight-line)
Commercial property → 39 years (straight-line)
Land is not depreciable
Depreciation reduces taxable income but does not reduce cash flow
This baseline depreciation alone has the potential to materially increase any after-tax returns
Accelerated depreciation in real estate typically comes from two tools:
Cost Segregation
A cost segregation study identifies portions of a building that can be depreciated over shorter lives:
5-year property
7-year property
15-year land improvements
Remaining building continues at 27.5 or 39 years
Bonus Depreciation (IRC §168(k))
When eligible, shorter-life components may qualify for bonus depreciation, allowing large portions to be deducted in Year 1 (subject to current law and phase-in rules).
The result: More depreciation sooner. This is primarily a timing strategy, not a permanent tax elimination strategy.
Residential Rental
Cost segregation often reclassifies:
Appliances
Flooring
Cabinetry
Certain electrical/plumbing components
Commercial Real Estate
Often yields larger acceleration due to:
HVAC systems
Parking lots
Site improvements
Specialized build-outs
Delaware Statutory Trusts (DSTs)
DST investors may receive:
Cost segregation studies provided by DST sponsors that they can directly use when filing their returns
Pass-through cost segregation benefits executed at the sponsor level
Potential for sheltering a portion of any distribution income from taxes
Depreciation deductions can have a significant impact on increasing any after tax income. Use of accelerated plus bonus depreciation can potentially not only eliminate income taxes – but generate a paper loss which can be carried forward to potentially increase after tax income in future years.
Following are several scenarios showing potential outcomes of utilizing different depreciation options.
These examples are based on the following investment assumptions:
Rental property purchase price: $1,500,000
Land: $300,000
Building: $1,200,000
Annual cash flow before depreciation of 6%: $90,000
Federal marginal tax rate: 37%
Scenario A — Standard Straight Line Depreciation Only
Scenario B — Cost Segregation + Bonus on Shorter Life Assets
Assume cost segregation reclassifies:
$300,000 to 5/7-year property
$150,000 to 15-year improvements
Remaining building: $750,000
If eligible for bonus depreciation:
Result: Full gross income of $90,000 is sheltered from taxes + large year-1 paper loss.
These scenarios are, of course, for informational and mathematical illustrative purposes only. They are not, nor can there be, a guarantee that any investment will achieve its stated objectives.
Boost Any Early After-Tax Yield
More deductions early = higher spendable cash.
Offset Other Passive Income
Useful for investors with multiple real estate holdings.
Potentially Improve Internal Rate of Return (IRR)
Tax deferral may help enhance early-year performance metrics.
Create Optionality
Losses may carry forward and offset any gains upon disposition.
Accelerated depreciation is powerful — but not risk-free.
Depreciation recapture
When you sell:
Accumulated depreciation is subject to recapture tax up to 25% federally
Short-life components may trigger different recapture treatment
Acceleration often shifts taxes forward — it does not eliminate them.
Large paper losses are useless if you cannot use them.
Cannot offset W-2 or portfolio income (in many cases)
Benefits may be delayed until future passive income or sale
Overly aggressive cost segregation
Poorly documented or aggressive classifications may:
Increase audit risk
Result in reclassification and penalties
Cash Flow Mismatch
Investors sometimes:
Assume tax savings = permanent savings
Spend the early tax windfall
Face higher taxes later without planning for recapture or a subsequent 1031 exchange
Cost segregation study costs
Many DST sponsors provide cost segregation studies to investors at no added cost
If a cost segregation study is not provided, costs can range from $1,500 to $10,000+ and investors should first calculate if they will receive a significant return prior to purchasing a study
Tax strategy is partially outsourced to sponsor execution.
Among the many potential benefits of owning investment real estate is the ability for investors to reduce their taxable income through taking advantage of allowed tax deductions such as depreciation. For many investors, using traditional straight line depreciation may be sufficient for them to meet their income goals while minimizing potential higher depreciation recapture taxes that may result from use of accelerated depreciation.
Accelerated depreciation works best when:
You plan to hold long-term or execute a 1031 exchange
You model recapture scenarios in advance
You reinvest tax savings productively
You have other passive income to offset
It is less powerful when:
You cannot use passive losses
You expect short holding periods without 1031 planning
You rely solely on projected tax savings to justify returns
We encourage all our clients to review their current retirement plans to determine if they still meet their objectives. A common complaint that we hear is that yields on invested funds are often not sufficient to meet planned retirement goals.
For more information, be sure to download a copy of my popular book entitled Real Estate Tax Deferral Strategies Utilizing the Delaware Statutory Trust (DST) – 2nd Edition.