Top Strategy for Real Estate Investors – Maximize Depreciation Deductions and Reinvest the Savings

One of the most powerful tools available to real estate investors is depreciation—a non-cash deduction that shelters rental income from taxes. While many investors are familiar with the standard 27.5-year (residential) or 39-year (commercial) depreciation schedule, fewer take advantage of an advanced strategy known as cost segregation to accelerate those deductions. All of my advanced clients use cost segregation studies on every possible property.

What Is Cost Segregation?

Cost segregation is an engineering-based analysis that breaks down a property into its component parts—structural vs. non-structural assets. Instead of depreciating the entire building over 27.5 or 39 years, cost segregation allows certain elements (like flooring, cabinetry, lighting, and even landscaping) to be reclassified into shorter class lives of 5, 7, or 15 years.

This reclassification front-loads your depreciation deductions—putting more cash in your pocket today.

Why Does This Matter?

Accelerated depreciation through cost segregation can significantly reduce taxable income in the early years of ownership, improving cash flow and increasing ROI. But this stratgey can be doubled or more when paired with bonus depreciation.

Bonus Depreciation: Supercharging the Benefit

Under current law, bonus depreciation applies to all property with a class life of 20 years or less. That includes most of the components identified in a cost segregation study. Here’s how it works:

• 100% bonus depreciation was allowed through 2022

• It began phasing down as follows:

  • 80% in 2023

  • 60% in 2024

  • 40% in 2025 (this year)

  • 20% in 2026

  • Expires in 2027 unless extended by Congress

This means that a property placed in service today can still claim 40% bonus depreciation on eligible components in addition to their regular accelerated schedule.

A Strategic Lens: Depreciation as an interest-free loan—And sometimes it can be forgiven

It’s helpful to think of depreciation not as a “free” benefit, but rather as an interest-free loan from the government. You deduct it today to reduce your taxes—but you may need to “pay it back” later when you sell the property through depreciation recapture.

But here’s the nuance: that repayment is often at a discount. Depreciation is deducted against ordinary income (up to 37%), but upon sale, it’s generally recaptured at a maximum rate of 25% (under §1250). That tax arbitrage—deducting high, repaying low—is a built-in advantage of the tax code. That is often around a 33% discount.

Example:

An investor buys a $2 million property and, through cost segregation and bonus depreciation, deducts $600,000 of accelerated depreciation in Year 1. Assuming a 37% marginal tax rate, the investor reduces their tax bill by $222,000 that year.

Years later, the property is sold. The $600,000 of depreciation is recaptured at 25%, resulting in a $150,000 tax bill.

Net benefit: $72,000 of permanent tax savings.

That’s a government-backed, interest-free loan—paid back at 67 cents on the dollar. You would never turn down a 33% discount on a new car or even a new shirt.

When Is the Loan Forgiven?

Under the right conditions, you may never pay it back at all:

• Section 1014 (Step-Up in Basis at Death): If the property passes to heirs, all depreciation is eliminated and basis resets to fair market value. The loan is fully forgiven. This doesn’t apply to all estates, so make sure your estate plan has a 1014 component to it.

• Charitable Gifts (§170): If you donate appreciated property to a qualified charity or donor-advised fund, no depreciation recapture is triggered.

• Keep Deferring (§1031 and §721): These strategies don’t eliminate recapture, but they do extend the deferral indefinitely—allowing you to reinvest pre-tax dollars.

Final Word: Don’t Spend It—Invest It

Because depreciation can be clawed back, the tax savings should be invested, not consumed. Think of it like this: if the government fronted you $200,000 in depreciation-based tax savings, and you used it to buy a boat, you’ll be in trouble when the tax bill eventually comes due. But if you put it into another income-producing asset (or use it to pay down debt), you’re now leveraging tax deferral to build lasting wealth.

That’s being smarter about taxes.