Real Estate Depreciation: A Strategy for Saving Money on Taxes?

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As a long termΒ real estate investor,Β tax shelter is almost always a popular topic for sure. Who doesn’t love the idea of a paper loss (paper = pretend) against their ordinary income, right? For the record, ‘ordinary’ income is what the Internal Revenue Code (IRC) calls your job income. I’ve never liked that. πŸ™‚ Anywho, in terms of real estate investment property tax shelter comes mostly in the form of depreciation.

Depreciation is merely the acquiescence by the IRS that physical property β€” mostly buildings and what goes in ’em β€” deteriorate over time, losing ‘value’. So they give it a ‘life’, so to speak. Generally speaking, residential income property will last 27.5 years according to the seers at the IRS. Apparently commercial property eats better and exercises as they’re expected to live longer, 39 years or so. In my experience, the residential side has seen as short as 15 years, though pretty quickly that term was lengthened to 19 years. Man, those were the days.

Back in my youth, before indoor plumbing and running water, there was no limit to how much depreciation a taxpayer/investor could apply to their ordinary income. They either had a legit amount of it and applied it, or they didn’t. Also, the same rules applied whether they made $30,000 a year at work or $30,000 a week. Depreciation was depreciation. But that was far too easy, right?

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Rules β€” There are Rules.

Want to amass tons of depreciation so your income taxes are slashed to almost nothin’? Dream on. With the exception of qualifying for Professional Investor status via IRS standards, you’re limited to a maximum of $25,000 yearly against your ordinary income. The rest? It gathers dust on the shelf ’til it’s finally allowed to be used. But, as you might’ve suspected, there’s a little hitch. There’s always a little hitch, right?

As soon as your ordinary income breaches the six figure level, you begin the trek to becoming completely persona non gratis when it comes to the ability to apply legitimate depreciation against job income. From $100,000 to $150,000 the IRS gradually reduces the percentage of the available depreciation eligible to be applied to your ordinary income to zero. For example, if you made $125,000 this year, and had $25,000 of depreciation left over after sheltering your properties’ cash flow, you’d only be allowed to take $12,500. That’s cuz you’d be half way from the maximum of $100,000 income to the maximum allowed income of $150,000. Once you succeed in earning $150,000 a year at work? No more depreciation for you. You’re done, put a depreciation fork in you.

You make over $150,000 β€” How do you use depreciation to reduce income taxes?

The cash flow generated from real estate bought for investment is safe. I used to feel confident in saying it’ll always be safe, but given all the changes in recent times, I’ll just say cash flow is safe for now. The other way to save taxes on your income is to apply unused depreciation on a particular property you’ve sold, which produces a capital gain. Though you’ll owe the capital gains tax due, the property’s unused depreciation will now break the IRS shackles and rush to the aid of that year’s ordinary income. Here’s an example.

Let’s say an investor making $250,000 a year at work, sells a property generating an impressive capital gain, upon which he’ll be taxed. During this property’s holding period there was approximately $100,000 dollars of unused depreciation warehoused. That $100,000 gets pushed immediately over to their job income, as the property producing it has been sold. To the extent it then ‘shelters’ that investor, that is, lowers the amount of income tax owed that year, it helps or some cases completely offsets his capital gains tax. Furthermore, if this example had used an investor making less than $100,000 at work, he would’ve also been allowed the annual limit of $25,000 depreciation that year. Thing is, most folks making under six figures don’t accumulate too much unused depreciation in real life.

Cost Segregation is more universally employed to cover BigTime cash flow.

What if you could take humungous yearly cash flow for five years without any of it, or at least very little being taxable? That’s the main attraction most investors use it for. Imagine being able to recoup much if not all of your down payment in untaxed cash flow in five years. Sure, there’s a terrific downside in that cash flow from that point forward would be all but naked. But many don’t worry about that since at that point they view themselves as operating on ‘house money’ so to speak. They then have a mostly taxable income stream, but with most/all of their original skin in the game back in their Levis.

Related: BP Podcast 017 – Finding Mentors, Facing Retirement, and Note Investing with Jeff Brown

What’s your ‘right’ question?

Though this has barely touched all that’s possible, you can readily discern that depreciation as a factor in long term real estate investment is often under utilized. There’s a problem though in that some investors base too much of their purchase decisions on tax shelter. Saving taxes is cool. Long term investing is generally for retirement income. After tax income. The timing of tax shelter, and what depreciation strategy should be employed are usually important. Still, the downside of executing a strategy that’s a bad fit can backfire at exactly the wrong time β€” retirement.

Use depreciation as a tool, like anything else.

Photo: Let Ideas Compete

About Author

Jeff Brown

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.


  1. Kenneth Estes

    Heya Jeff,

    You didn’t mention that you have to pay that depreciation back when you sell the property. Assuming your real estate actually appreciates in value. That allows you to eat up a lot of passive losses sitting on the shelf.



    • Jeff Brown

      Depends on the strategy used, Keny. Typically, ‘normal’ boring depreciation isn’t subject to recapture taxation, merely part of the formula for figuring capital gains, if any. The difference between cap gains and depreciation recapture taxes is significant. Most investors find themselves at the 15% rate for cap gains. However, if you opted for a depreciation strategy that allows more than ‘subtract the land value and divide by 27.5 years’ you’ll be subject to 25% as a tax rate on the recapture amount. Ouch.

      This is why I pound so much on having a highly focused purpose in every facet of your investment plan. Make sense?

      • Kenneth Estes

        Hey Jeff,

        You’re going to have to help me out.

        Any 27.5 year property for which you claim depreciation deductions will have to be fully recaptured when you sell (assuming of course the sales proceeds are sufficient). Even the “normal boring depreciation.” If you’re investing as an individual, LLC, or S-corp, this depreciation recapture passes through and is taxed at your personal tax rate rate, which isn’t necessarily 25%.

        Sales proceeds above and beyond “full recapture” will be taxed at the capital gains rate of 15%, assuming you’ve held it for more than a year.

        I’d sincerely love to hear a depreciation strategy which allows you to get around this. It could potentially save me a lot of money.



        • Robert Steele on

          Sorry but I find this article confusing. Not because of what is outlined but because of the use of the word depreciation in some places where it should read as passive income loss.

          Other than that there are some interesting techniques in this article. I have successfully used cost segregation to accelerate depreciation. I also file with the IRS Real Estate Professional status mentioned but unfortunately it doesn’t help shelter my earned income anymore because my properties no longer generate passive losses.

          Kenny is right. There is no way to get out of depreciation recapture other than doing an exchange.

        • Kenny β€” Was wall to wall yesterday. I’ve got my reply for you ready to go, but wanted to clear it with one of the CPAs I use to ensure it was 100% accurate.

        • Jeff Brown

          Hey Kenny β€” Let’s give it a shot. Sorry for the delay. I’ve been wall to wall lately, plus I wanted a highly qualified CPA, versed in RE investment tax laws to review my answer.

          First off, this statement is inaccurate:

          “Any 27.5 year property for which you claim depreciation deductions will have to be fully recaptured when you sell (assuming of course the sales proceeds are sufficient).”

          It’s inaccurate due to the use of the word ‘recaptured’ which is a very meaningful concept, not to be confused with anything else. 27.5 year property is considered ‘straight line’ and NOT subject to recapture taxes. They are indeed incorporated in the formula used to compute adjusted cost basis at the time of sale, which then affects the ultimate realized capital gain. Recapture tax simply doesn’t apply to 27.5 year property. The word ‘recapture’ has a very specific meaning when coming from the lips of the IRS. πŸ™‚

          When personal (and sometimes real) property is given separate life, i.e., 5-15 years, it IS subject to recapture tax. Also, there’s a huge difference in how tax returns are structured in the year of sale of real estate held for investment. Software tax return products are a joke when it comes to this level of taxpayer. I won’t even debate that, and I suspect you wouldn’t either.

          But the point in tax return structure is the glaring lack of real estate investment tax law knowledge demonstrated by far too many tax preparers. If most practitioners of tax preparation are unaware of the intricacies of how to report/structure tax returns incorporating non-straight line depreciation, imagine even an experienced investor’s problem. It’s not that they can’t find the answers to their questions. They don’t know many of the crucial questions to ask. If they don’t know the questions, they don’t realize there’s a problem β€” a problem they’ve sometimes created.

          CPAs who’re truly bona fide real estate investment tax experts in the OldSchool sense, will tell us that even non-straight line depreciation can avoid much if not all recapture taxation if the sale of the subject property is structured correctly. That subject itself is involved and relatively complex, another understatement.

          Let’s take a taxpayer earning $550k/yr living in CA. HIs marginal tax rate, fed/state is about 48.9% if he’s filing married/jointly. If he has unused depreciation from a sold property of $100k it is allowed to be taken from his ordinary income in the year of sale. This means he just saved almost $49k in income taxes that year. How much that might offset his cap gains or recapture taxes will clearly depend on his specific adjusted cost basis vs sale price computation. In any event, that’s a buncha dead presidents remaining in his Levis that year.

          The investor/taxpayer rarely if ever ‘gets around’ either cap gains or recapture tax. As I’ve implied above rather strongly most taxpayers pay more in recapture tax than they need to, due to inferior tax preparation. What they do accomplish is the ability to take impressive amounts of unused depreciation against their ordinary income in the year of sale, regardless of how much they may’ve earned that year over the $150k/yr limitation. It’s THAT tax saving that can potentially offset much if not all of of a cap gains/recapture tax liability.

    • From my understanding the property doesn’t need to appreciate at all to be hit. If you own a house for 30 years you have maxed out depreciation. If you bought for $100,000 and happento sell for $100,000 30 years later you just pay taxes on the gains based on what you depreciated. So if land was worth $20,000 then you still owe taxes on $80,000 at sale. If however you shelved all drepreciatio. Then you would apply that $80,000 in appreciation upon sale and owe no taxes.

  2. Jeff, I did not completely understand the strategy in your second-last paragraph.

    Are you saying here that an investor could take one fifth depreciation each year for 5 years instead of taking one 27th?

    If I am understanding correctly…. For an $80,000 house ($100,000 including lot); each year, the investor takes $16,000 in depreciation (20%) and at the highest tax rate reduces his income taxes by 35% $5,600. Do this for 5 years and taxes were reduced by $28,000 in total. Thus the investor has cash to invest in another property.

    This same investor would be completely exposed in years 6+ for all cash flow income and would be exposed to full Capital Gains tax on the entire sale price whenever they sell the property, even if their cost basis was $80,000 to begin with.

    Did I understand that example correctly?

  3. Hey Marc β€” Well, you have some of it right. In Cost Segregation, the method to which I referred, takes the various components of the building (and some not ‘of the building’) and gives them much shorter separate lives. This avoids lumpin’ everything into the ‘divide the improvements’ (pretty much everything but the land) by either 27.5 years for residential, or 39 for commercial.

    So, you have electrical, foundation, roof, plumbing, etc. What you’re definitely NOT doing is simply dividing the improvement value by 5 and taking that. We’d all love that, but that’s not the case. Typically, depending on the type property, Cost Segregation will generate 2-5 times the ‘normal’ method.

    You’re correct about the investor being almost totally without tax shelter once the first 5 years or so pass. There are a couple main reasons an investor would knowingly do this.

    1. The tax sheltered cash flow was so much during those 5 years, they recovered all or much of their original down payment. At that point they’re taxed silly, but they’re playing with ‘house’ money at that point, at least from their standpoint.

    2. Big ordinary income earners β€” more than $150k/yr β€” come from a different angle. They use CS, knowing they’re barred from using depreciation leftover from sheltering cash flow against their ordinary income. They then sell the property(s) for a gain, knowing they have several years, usually 5, of unused depreciation. They take it off the shelf, dust it off, and apply it to their ordinary income in the year of the property’s sale. This usually will offset a very significant portion of the incurred cap gains/depreciation recapture taxes.

    As you so accurately observed, Marc, if they opt to keep a property after CS depreciation has been mostly exhausted, their cash flow from that property will be pretty much naked at tax time.

    Hope this helped.

  4. Great topic Jeff. I would love to see a part two to include many of the questions already asked. My question would be on forced depreciation and depreciation recapture. While I think I understand the concept, I would live to see your laymen terms take on it.

    As a side note, there is always the real estate professional route down the road to take that upfront before inflation money through depreciation. I’ll gladly take $3000 now to payback a less valuable $3000 in the future. All the while investing the originally 3k.


  5. Hey Robert β€” You never get out of recapture, but you can provide an ‘offset’ via your personal income tax return in the year of sale. I didn’t mean to confuse. I use the word ‘depreciation’ as it’s used in the vernacular far more than passive income loss. We’re on the same page.

    So, in the end the investor pays owes any recapture tax or cap gains tax due at sale. Then, if they have a boatload of unused depreciation it’s applied to their ordinary income tax return. Any rules disallowing them to use depreciation against ordinary income due to their $150k/yr+ income no longer applies. So, if they have a cap gains/recapture tax of say, $50k, but save $40k in ordinary income tax return that year, you can see how they benefit.

  6. Matt DeVincenzo on

    Great post Jeff. While I’ve heard or researched of a lot of the topics you discuss, I just recently have started to see how you and others use them together to really plan for the future. You’re definitely one of the contributors here on BP I love to look for every week.

    I’m out in San Diego not far from where you are and would love to meet with you sometime and really start to put a focused plan in place like you so often talk about in your posts. Again great article Jeff.

  7. I’m encouraged that depreciation for those with W2 above $150k is still useful but down the road. Then it brings up the question going the cost segretion route on my 9 rentals, that I’ve owned several years.

    Is CS something I can do myself in front of my turbo tax business? Sounds doable since I’m good with numbers and the concept seems straight forward. So why not?


    • Jeff Brown

      Hey Curt β€” I’d rather you walk on a bed of crushed glass barefooted than try CS as a DIY project on a piece of software. πŸ™‚ I will give ya a piece of decent news though. Generally speaking, you can go back a number of years (can’t remember offhand how many), after the fact and amend previous tax returns, applying CS. Don’t believe a word of that though. Believe a tax preparation expert β€” and make sure they’re human. πŸ™‚

  8. LOL! Nothing like a good “visual” to sink the point home. I’m a doer so had to ask.

    Another depreciation issue is (or is now a: was?) the section 179 election where a depreciatable item could be written off 100% in the first year. I think it was apart of the economy jump start bill/program. I always felt that was an audit bait. There’s probably worse audit baits or was guessing wrong. So I took few if any of the 179 elections when they where offered as a choice (by turbo tax business). Anyone’s opinions on the benefit or hidden consequences taking election 179? I’m in the over $150k category so it wouldn’t have benefited me immediately anyway.

    Re my decision to not take the 179 election I had a sneaky alterior tactic as to why I didn’t take all those deductions over 9 rental rehabs. I’m a computer and algorithm type guy and I left those not taken 179 deductions in my tax returns as safety parachutes left in place in case I get audited that what ever damages the IRS assesses, since the tax return is cracked open, I would check box all those 179’s to negate and probably come out ahead. I know that the IRS has computers and algorithms looking for patterns and I suspect (since I write software) that those computers run what-if scenarios on each return to judge the value (more cash collected) and I feel my un-taken 179’s cause my return to be passed over since it’s likely that any accidental error I’ve made would be negated by taking the 179 deductions. Now this assumes that when being audited the return is open for that kind of amendment? πŸ™‚ I bet an accountant would not have advised that clever of an audit avoidance strategy? LOL Maybe I outsmarted myself again, but regardless I sleep better.


    Thanks, curt

  9. Also Jeff, re amending past returns, yes that is exactly how a real estate investor friend caused their return and then prior 5 years of returns to get audited. Yup it was an eager new accountant wanting to show their value urged that they file an amended return, changing strategies and values for deductions etc. I’ve heard 2 top CPAs advise that REI folks should do their own taxes just for this reason plus unless you have some unusual situation rentals and or wholesaling are not complicated tax events (per them). I guess excepting cost segregation.

    We’ll what is not well appreciated is, that when you sign your return and mail it in, you are swearing that all is truthful. You are guaranteeing an audit if you file an amended return materially changing your return. The amended return says your first return was not truthful and you might as well sell a few houses to pay for your legal troubles at the same time you mail your amended return. I probably stretched the audit risk with filling an amended return but my friends experience taught me to just forget about the amend your return tactic and to be leery of tax accountants who say they can save you $$ on your return when you are interviewing for services! My view is that you need to know how the tax code works to best run a real estate business.


    • Jeff Brown

      Hey Curt β€” I’ve been audited once in the last 36 years. The guy was a veteran, and after less than an hour, he smiled, accepted my offer of some killer good coffee, then went home. I’ve amended returns without problems. My experience is that when we provide backup, attached to the return, many potential glitches are avoided.

      I’ve never used a one year life on anything, or known anyone who has.

  10. Hi Jeff,

    Great blog post. I really enjoyed reading it. I have one remaining issue that I am still confused about. It is my understanding that under 1(h)(1)(D) any gain on previously depreciated 1250 property is taxed at a 25% rate (assuming it is not depreciation recapture and taxed at ordinary income rates). This would apply to any amounts that were depreciated using MACRS straight line depreciation. I understand it is called unrecaptured 1250 gain — and as I recall there is a worksheet attached to Schedule D that is used to compute it.

    However, what I get from your post is that any gain on previously straight line depreciated 1250 property is only taxed at LT capital gains rates — not the higher 25% rate.

    So, for example, if I purchase an apartment building in 2000 for $100,000, and for the sake of argument, depreciate $30,000 using straight line depreciation on the MACRS schedule, then later sell it for $150,000 — putting aside selling costs, i think i will be taxed at ordinary ltcg rates for the 50,000 appreciation gain, and at a rate of 25% for the 30,000 unrecaptured 1250 gain.

    Can you confirm that? Am I misunderstanding the 25% rate? I just ask because I am a bit confused by your post and the code.



  11. Jeff,

    Thank you for the info you have provided. One question – how does applying depreciation against ordinary income apply if there are multiple owners of an asset or real estate company that owns assets?


    • Jeff Brown

      It depends, Marc. But the short answer is that if it’s set up such that investors can share, it’s usually by way of their percentage of ownership. They can’t always share though. It’s something you surely should talk about with your CPA.

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