Tax Planning for Rental Property Owners: Depreciation, Cost Segregation, 1031 Exchanges, and Loss Deductions

Rental real estate has been called the most tax-favored investment in America, and the description is accurate. No other asset class provides the combination of (1) current income that’s partially or fully sheltered by depreciation, (2) appreciation that is taxed at favorable long-term capital gains rates, (3) indefinite deferral through 1031 exchanges, and (4) permanent elimination of deferred gains through the step-up in basis at death. Under IRC 168, residential rental property is depreciated over 27.5 years using the straight-line method (mid-month convention), producing an annual depreciation deduction of approximately 3.636% of the building’s depreciable basis (land isn’t depreciable). For a $1,000,000 property with a $200,000 land allocation, the annual depreciation on the $800,000 building is approximately $29,091. This depreciation is a non-cash deduction that reduces taxable income without reducing actual cash flow, which is why rental real estate can produce positive cash flow while reporting a tax loss. Cost segregation studies under IRC 1245 and IRC 1250 reclassify building components into shorter-lived asset classes, dramatically accelerating the depreciation schedule.

How does rental property create tax benefits?

Does bonus apply to cost seg parts of a used rental building?

Yes. When you buy an existing apartment building, the 5-, 7- and 15-year components a cost segregation study identifies are used property, and used property qualifies for bonus if you bought it from an unrelated seller and didn’t use it in the five calendar years before the year you placed it in service, or earlier in that year. For property acquired after January 19, 2025, the rate is 100%.

Section 179 is a different story for most owners, since it doesn’t cover rental property unless renting is your trade or business. The 27.5-year building shell gets neither, because bonus stops at a 20-year recovery period. And rental activities are passive by default, so a large bonus-driven loss may be limited, as the table above shows.

Can a rental owner expense the building instead of 27.5 years?

No. A residential rental building is depreciated straight line over 27.5 years with a mid-month convention, and there’s no faster option for the shell. Bonus depreciation only reaches property with a recovery period of 20 years or less, and Section 179 generally doesn’t cover rental property unless renting is your trade or business.

The choice shows up only for the parts a cost segregation study pulls out. Those get 100% bonus by default if acquired after January 19, 2025. To keep them on regular MACRS instead, you’d elect out for the whole class of property for that year, and that election can be revoked only with IRS consent. Whether that’s worth doing is a planning call, since rental losses are passive by default and a big first-year loss isn’t always usable. For the portfolio view, see Tax Planning for Rental Property Investors.

• Tax Planning for Rental Property Investors: Depreciation, Passive Loss Rules, and Building a Tax-Efficient Portfolio

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.