Real Estate Tax Benefits: Depreciation & 1031 Exchanges

Depreciation is the tax deduction people find most appealing about rental property and least accurately described. It's real, it's large, and for most W-2 earners it doesn't do what they've been told it does.

Last verified 2026-07-21

A deduction for money you didn't spend

The IRS treats a residential rental building as wearing out over 27.5 years and lets you deduct a slice of its value annually — even though the building may be appreciating and you spent nothing that year. That's what makes it unusual: a deduction with no cash outflow behind it.

Only the building depreciates. Land doesn't, so the purchase price has to be split between the two, and the allocation matters — a higher building share means a larger annual deduction, which is why property tax assessments and appraisals get used to justify it.

Two refinements the headline figure hides. The first and final years are prorated under the mid-month convention, so year one is never a full year's deduction. And commercial property runs over 39 years rather than 27.5, so the same building generates a noticeably smaller deduction if it's an office rather than apartments.

The rule that stops it working for most people

Rental activity is generally passive under §469, and passive losses can only offset passive income — not your salary. So the depreciation deduction that produces a paper loss usually cannot reduce the tax on your job.

There's a special allowance of up to $25,000 for active participants, but it phases out between $100,000 and $150,000 of modified AGI and disappears entirely above that. Which means the higher your W-2 income, the less the headline benefit applies to you — the opposite of how it's usually pitched.

The losses aren't destroyed. They're suspended and carried forward, released against future passive income or in full when you sell the property. Real estate professional status can change the analysis entirely, but it has demanding hour requirements that a full-time employee will not meet.

The bill arrives when you sell

Every dollar of depreciation you claimed reduces your cost basis, so it increases the gain when you sell. That portion is unrecaptured §1250 gain, taxed at your ordinary rate but capped at 25% — a ceiling, not a flat rate, so someone in a low bracket pays less than 25%.

This is why depreciation is best understood as a deferral with a rate advantage rather than free money: you deduct at your ordinary rate now and pay back at a capped rate later, with the use of the money in between.

A 1031 exchange defers the whole thing by rolling proceeds into a like-kind investment property through a qualified intermediary, on a strict clock — 45 days to identify the replacement and 180 days to close. Chain enough of them and the deferral can run until death, at which point the heirs' stepped-up basis can wipe out the accumulated gain entirely.