Depreciation

Let's say you buy a rental property building for $200,000. Instead of deducting the full cost in year one, the IRS lets you write off a slice each year over 27.5 years—roughly $7,273 annually. That deduction reduces your taxable income without you paying another dime out of pocket.

For rental property owners, depreciation is a game-changer. It can create "paper losses" even when a property is cash-flow positive. A rental netting $1,000/month ($12,000/year) with $7,273 in depreciation only shows $4,727 in taxable income—and it might even show a loss once you factor in other deductions.

Different assets depreciate on different schedules: residential rental property takes 27.5 years, commercial property 39 years, computers and equipment 5 years, vehicles 5 years, and furniture 7 years. Section 179 and bonus depreciation can speed things up dramatically—sometimes letting you write off the entire cost in year one.

The catch is depreciation recapture. When you eventually sell a depreciated asset, the IRS "recaptures" those earlier deductions at a 25% rate (for real estate) instead of the lower capital gains rate. If you depreciated $100,000 of a property, that's $25,000 in recapture tax on top of any capital gains tax.

A 1031 exchange can kick that recapture down the road by swapping into another property. This is why many real estate investors never actually sell—they exchange, keep depreciating, and defer taxes indefinitely. If they pass the property to heirs, the stepped-up basis may wipe out the deferred tax entirely.