Depreciation is the IRS's acknowledgment that physical assets wear out over time. For residential rental property, the IRS allows you to deduct the cost of the structure (not the land) over 27.5 years. This non-cash deduction offsets rental income, often sheltering it entirely — and in some cases creating a paper loss that carries forward.
How does depreciation actually reduce your tax bill?
When you own a rental property, you report rental income and deduct operating expenses — mortgage interest, property taxes, insurance, repairs. Depreciation is an additional deduction layered on top. A $400,000 residential property with $100,000 allocated to land generates a $300,000 depreciable base. Over 27.5 years, that's roughly $10,900/year in depreciation deductions, regardless of whether you spent a dollar on repairs.
If your rental income is $24,000/year and your operating expenses are $12,000, your net is $12,000. Add $10,900 in depreciation and your taxable income drops to $1,100. In many cases the depreciation exceeds income and produces a passive loss.
What is cost segregation and why does it matter?
Standard depreciation treats a building as a single asset over 27.5 or 39 years. Cost segregation is an engineering study that reclassifies components of a building into shorter depreciation categories — 5, 7, or 15 years for things like appliances, flooring, landscaping, and certain structural elements. This accelerates depreciation deductions into earlier years, dramatically increasing the tax benefit upfront.
A cost segregation study typically costs $5,000–$15,000 depending on property size. On a $1M+ commercial or multifamily property, reclassifying 20–30% of the asset into 5–15 year categories can generate six figures in accelerated deductions in year one — particularly powerful when combined with bonus depreciation rules.
What are passive activity loss rules?
The IRS limits how passive losses can be used. Rental real estate losses are generally passive and can only offset other passive income — not W-2 wages or business income. There's a $25,000 special allowance for active participants with adjusted gross income under $100,000, phasing out completely at $150,000.
The exception: Real Estate Professionals (REP status) can deduct unlimited rental losses against any income if they spend more than 750 hours per year in real property trades or businesses and more than half their working time in real estate. For founders who own substantial real estate portfolios, qualifying as a REP is a significant tax lever — but it requires meticulous documentation of hours.
What happens to depreciation when you sell?
The IRS claws back depreciation through depreciation recapture at sale. The previously deducted amount is taxed at a maximum rate of 25% (Section 1250 unrecaptured gain) rather than the standard long-term capital gains rate of 0–20%. This is a known cost — you're essentially deferring income from high-rate years to a flat 25% on exit, which is often still a net win.
A 1031 exchange allows you to sell a property and reinvest the proceeds into a like-kind property while deferring both capital gains and depreciation recapture indefinitely. Structured properly, you can roll gains forward across properties and eliminate the recapture through stepped-up basis at death.
Verdict
Depreciation is one of the few genuine tax advantages available to US founders inside the domestic tax system. It's not glamorous, but a properly structured real estate portfolio — with cost segregation on acquisition and 1031 exchanges on disposition — can shelter significant income over a founder's career. The rules are complex enough to warrant a qualified CPA, but the mechanics are well-established and fully legal.
Frequently Asked Questions
Can non-US residents depreciate US property?
Yes. Non-resident aliens who own US rental property can depreciate it on their 1040-NR. The same 27.5-year schedule applies. Passive loss rules also apply — losses generally carry forward until the property is sold.
Does depreciation reduce my cost basis?
Yes. Each year of depreciation reduces your adjusted cost basis in the property. When you sell, your gain is calculated against this reduced basis, increasing the taxable gain. This is the trade-off: deductions now, larger taxable gain later.
What is bonus depreciation?
Bonus depreciation allows immediate expensing of certain qualified assets in the year of purchase rather than spreading deductions over the depreciable life. The TCJA set bonus depreciation at 100% through 2022; it has been phasing down at 20% per year since then. Cost segregation studies identify assets eligible for bonus depreciation.
How do I track depreciation across multiple properties?
Your CPA or tax software maintains a depreciation schedule for each property. For larger portfolios, specialized real estate accounting software (AppFolio, Buildium, or QuickBooks with real estate add-ons) can automate this. Never manually track depreciation across more than a couple of properties — the error surface is too large.