Real estate offers tax advantages that most other investments simply can’t match. The combination of depreciation deductions and 1031 exchanges allows investors to reduce current taxes, defer future taxes, and keep more capital compounding in their portfolios over time.
This guide covers how depreciation works for rental properties, the mechanics and deadlines of 1031 exchanges, and how cost segregation studies accelerate your deductions—plus the documentation you’ll want to keep the IRS satisfied. If you want these tactics aligned with your broader portfolio and reporting decisions, a Fractional CFO for Real Estate can help you connect tax strategy to long-term capital planning.
Why Tax Strategies Matter for Real Estate Investors
Real estate investors reduce their tax liability primarily through depreciation deductions and 1031 exchanges. Depreciation lowers taxable rental income each year by allowing investors to deduct a portion of the building’s value. Meanwhile, 1031 exchanges defer capital gains and depreciation recapture taxes when selling one investment property to purchase another.
What makes real estate unusual among investment types is the ability to claim paper losses while the property actually goes up in value. You might own a rental property that appreciates $50,000 in a year, yet still report a taxable loss because of depreciation deductions. This disconnect between taxable income and actual cash flow is one of the most powerful wealth-building features in the tax code.
- Cash flow preservation: Tax savings stay in your pocket for reinvestment, repairs, or reserves
- Wealth compounding: Deferred taxes keep working for you rather than going to the IRS
- Exit planning: When and how you sell affects your long-term returns significantly
How Depreciation Works for Investment Properties
Depreciation is a non-cash deduction that lets you recover the cost of a building over its useful life. The IRS recognizes that buildings wear out over time, so investors can deduct a portion of the building’s value each year—even when the property is actually increasing in market value.
One important distinction: land cannot be depreciated. Only the building structure and improvements qualify. When you purchase a property, you’ll allocate the purchase price between land and building based on their relative fair market values.
Residential Versus Commercial Depreciation Schedules
The IRS assigns different recovery periods depending on property type. Residential rental properties use a 27.5-year schedule, while commercial and nonresidential properties stretch over 39 years.
| Property Type | Recovery Period |
|---|---|
| Residential rental | 27.5 years |
| Commercial/nonresidential | 39 years |
So a residential rental building worth $275,000 would generate roughly $10,000 in annual depreciation deductions. That’s $10,000 subtracted from your taxable rental income each year without spending anything out of pocket.
What Is Bonus Depreciation
Bonus depreciation is an accelerated deduction that allows investors to write off certain property components immediately rather than spreading them over many years. This applies to personal property within buildings—appliances, fixtures, carpeting, and certain improvements—not the building structure itself.
The bonus depreciation percentage has been phasing down recently. It was 100% for qualifying property placed in service through 2022, then dropped to 80% in 2023, 60% in 2024, and continues declining. Timing matters when planning major purchases or renovations.
Understanding Depreciation Recapture
Here’s the catch: when you sell a property, the IRS wants back some of what you deducted. Depreciation recapture taxes the accumulated depreciation you claimed at a rate of up to 25%—higher than the long-term capital gains rate for most investors.
This recapture mechanism is precisely why 1031 exchanges become so valuable. By exchanging rather than selling outright, you defer both capital gains and depreciation recapture taxes to a future date. (If you want a deeper walkthrough of deadlines, qualifiers, and planning considerations, see these 1031 exchange tax strategies for real estate investors.)
What Is a Cost Segregation Study
A cost segregation study is an engineering-based analysis that identifies building components eligible for accelerated depreciation. Rather than depreciating your entire building over 27.5 or 39 years, a cost segregation study reclassifies certain elements into shorter recovery periods—typically 5, 7, or 15 years.
How Cost Segregation Accelerates Deductions
The study separates your property into distinct asset categories, each with its own depreciation timeline:
- Land improvements (15 years): Parking lots, sidewalks, landscaping, fencing
- Personal property (5–7 years): Carpeting, appliances, decorative fixtures, window treatments
- Specialized systems (5–7 years): Security systems, certain electrical components, specialized plumbing
For a $1 million commercial property, a cost segregation study might reclassify $200,000 to $300,000 into shorter depreciation categories. Combined with bonus depreciation, this can generate substantial first-year deductions that would otherwise take decades to claim.
Who Qualifies for a Cost Segregation Study
Cost segregation typically makes financial sense for properties with an acquisition or construction cost above $500,000, though the threshold varies based on property type and individual circumstances. The study applies to purchased properties, new construction, and significant renovations alike.
The analysis requires qualified professionals—usually engineers or specialized CPAs—who understand both construction and tax law. Study fees typically range from $5,000 to $15,000, but the tax savings often exceed this cost many times over in the first year alone.
What Is a 1031 Like-Kind Exchange
A 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows you to sell an investment property and purchase another while deferring all capital gains and depreciation recapture taxes. The key word here is “defer”—you’re postponing the tax bill, not eliminating it entirely.
The IRS views the transaction as a continuation of your investment rather than a taxable sale. Your tax basis carries over to the new property, preserving the deferred gain until you eventually sell without exchanging.
Properties That Qualify as Like-Kind
Both the property you’re selling (called the relinquished property) and the property you’re buying (called the replacement property) have to be held for investment or business use. The good news is that “like-kind” is interpreted broadly for real estate.
- Qualifies: Rental properties, commercial buildings, raw land held for investment, industrial facilities
- Does not qualify: Primary residences, vacation homes used personally, property held primarily for resale like fix-and-flip inventory, foreign real estate
An apartment building can be exchanged for raw land. A retail strip center can be exchanged for a warehouse. The flexibility here is substantial, which is part of what makes 1031 exchanges so useful for portfolio repositioning.
The Role of a Qualified Intermediary
You cannot touch the sale proceeds and still complete a valid 1031 exchange. A qualified intermediary (QI) is a third party who holds the funds between transactions and handles the exchange documentation.
The QI receives the proceeds from your sale, holds them in a segregated account, and then uses those funds to acquire your replacement property. If you receive the money directly—even briefly—the exchange fails and taxes become due immediately.
Tip: Select your qualified intermediary before listing your property for sale. The exchange agreement typically has to be in place before closing on the relinquished property.
Key Rules and Deadlines for 1031 Exchanges
The IRS imposes strict timelines on 1031 exchanges, and these deadlines generally cannot be extended for any reason. Missing them by even one day disqualifies the entire exchange and triggers immediate tax liability—one reason many investors benefit from outsourced CFO leadership when coordinating timelines, liquidity needs, and documentation across multiple stakeholders.
The 45-Day Identification Period
Within 45 calendar days of selling your relinquished property, you have to identify potential replacement properties in writing. The identification goes to your qualified intermediary and follows specific rules about format and delivery.
The most common approach is the three-property rule: you can identify up to three properties regardless of their combined value. Alternative rules exist for identifying more properties, but they come with additional restrictions that make them less practical for most investors.
The 180-Day Exchange Deadline
You have to close on your replacement property within 180 calendar days of selling the relinquished property—or by your tax return due date including extensions, whichever comes first. This deadline runs concurrently with the 45-day identification period, not after it.
Boot and Partial Exchanges
“Boot” refers to any cash or non-like-kind property you receive in the exchange. If you sell a property for $500,000 but only reinvest $450,000, that $50,000 difference is boot—and it’s taxable in the year you receive it.
Partial exchanges are permitted under the tax code. You’ll defer taxes on the portion you reinvest while paying taxes on the boot. Many investors accept some boot intentionally when they want to extract cash while still deferring the majority of their gain.
How Depreciation and 1031 Exchanges Work Together
Depreciation and 1031 exchanges create compounding benefits when used in combination. Understanding how they interact is where tax planning becomes genuinely powerful for real estate investors.
Transferring Depreciation to Replacement Properties
When you complete a 1031 exchange, your tax basis carries over to the replacement property. This means the depreciation you claimed on the old property reduces the depreciable basis of the new one.
For example, if you purchased a property for $400,000, claimed $100,000 in depreciation, and exchanged into a $600,000 replacement property, your new basis would be $500,000—the $600,000 value minus the $100,000 of deferred depreciation. The recapture obligation follows you from property to property. It’s deferred, not forgiven.
Cost Segregation on Newly Acquired Properties
Here’s where it gets interesting: you can conduct a cost segregation study on properties acquired through 1031 exchanges. This allows you to accelerate depreciation on the new property while still benefiting from the deferred gains on the old one.
The result is a fresh round of accelerated deductions layered on top of your existing tax deferral. Investors who chain multiple exchanges together while conducting cost segregation studies on each new acquisition can defer taxes for decades while continuously generating new deductions.
Common Expense Deductions for Real Estate Investors
Beyond depreciation, rental property owners can deduct ordinary and necessary business expenses against their rental income. These deductions reduce taxable income dollar-for-dollar.
Operating Expenses and Repairs
Routine maintenance and operating costs reduce your taxable rental income in the year you pay them:
- Maintenance and repairs: Fixing leaks, repainting, replacing broken fixtures
- Insurance premiums: Property, liability, and landlord policies
- Utilities: When paid by the landlord rather than tenants
- Property taxes: Fully deductible against rental income
The distinction between repairs and improvements matters here. Replacing a broken window is a repair and immediately deductible. Replacing all windows with energy-efficient upgrades is likely an improvement that gets capitalized and depreciated over time. (Related: operating expense optimization for real estate investors can help you reduce NOI leakage while keeping documentation audit-ready.)
Property Management and Professional Fees
Fees paid to property managers, accountants, attorneys, and tax advisors are deductible business expenses. Legal fees for lease preparation, eviction proceedings, or tax planning all qualify as ordinary business costs.
Mortgage Interest and Financing Costs
Mortgage interest on investment properties is fully deductible against rental income—there’s no cap like there is for personal residences. Certain loan origination costs and points may be amortized over the life of the loan rather than deducted immediately.
IRS Compliance and Documentation Requirements
Proper recordkeeping protects your deductions if the IRS ever asks questions. Poor documentation can result in disallowed deductions or failed exchanges upon audit.
For depreciation, maintain purchase records showing your cost basis, any cost segregation studies, and annual depreciation schedules. For 1031 exchanges, keep the exchange agreement, 45-day identification letter, closing statements for both properties, and all qualified intermediary correspondence.
How Strategic Tax Planning Builds Real Estate Wealth
Depreciation, cost segregation, and 1031 exchanges work best as components of an integrated approach rather than isolated tactics. Used together, they allow real estate investors to minimize current taxes, defer future taxes, and keep more capital working in their portfolios over time.
The investors who benefit most are those who plan proactively rather than reactively. Knowing your exit approach before you buy, understanding how each property fits into your broader portfolio, and timing transactions with tax implications in mind can mean the difference between paying taxes now and deferring them for decades.
Talk to a Bennett Financials advisor to map out your real estate tax approach and ensure depreciation, cost segregation, and 1031 exchanges work together toward your specific goals—supported by a fractional CFO services partner who can coordinate strategy, reporting, and timing.
