Depreciation, Cost Segregation & Depreciation Recapture

December 2025

One of the defining characteristics of real estate investing is how it interacts with the tax code.

Depreciation, cost segregation, and depreciation recapture can materially influence after-tax outcomes, but they are often misunderstood. These concepts do not create economic value on their own – they affect when taxes are paid and how income and gains are recognized.

This article explains how depreciation works in real estate syndications, how cost segregation accelerates it, and what depreciation recapture means when an investment exits.

What Depreciation Is – and What It Is Not

Depreciation is a non-cash expense that reflects the IRS-mandated allocation of a property’s cost over time.

In practical terms, depreciation allows investors to deduct a portion of a property’s value each year, even if the property is generating positive cash flow.

It’s important to understand what depreciation does not represent:

• It is not a cash expense

• It does not reflect actual property wear in real time

• It does not eliminate taxes permanently

Depreciation primarily affects timing, not total economic return.

How Depreciation Works in Syndications

In a syndication, depreciation is allocated to investors based on their ownership interest.

These deductions may:

• Offset taxable income from the investment

• Reduce current tax liability

• Improve after-tax cash flow

Because depreciation is allocated regardless of whether cash is distributed, investors can receive cash flow that is partially or fully tax-deferred in earlier years.

How Passive Losses Can – and Cannot – Be Used

Depreciation typically creates passive losses for investors.

For most investors, passive losses:

• Can offset passive income from real estate, including income from other syndications

• Cannot offset active or wage income, or income from stocks and other non-passive investments

Unused passive losses do not disappear. They carry forward and may be applied in future years to offset passive income, or may be recognized when the investment is sold.

This is one reason depreciation tends to be most effective for investors who hold multiple passive real estate investments over time.

Cost Segregation – Accelerating Depreciation

Cost segregation is an engineering-based analysis that identifies components of a property that can be depreciated over shorter time periods. Rather than depreciating the entire property over a long schedule, cost segregation allows certain portions to be written off more quickly.

In syndications, this often results in:

• Front-loaded depreciation

• Larger deductions in early years

• Greater tax deferral earlier in the hold period

Under current law, accelerated depreciation may allow a significant portion of these deductions to be recognized earlier in the investment lifecycle, increasing the amount of depreciation available in initial years. Cost segregation does not increase total depreciation – it accelerates it.

Whether cost segregation is appropriate depends on factors such as asset type, purchase price, expected hold period, and investor tax profile.

Depreciation Recapture at Sale

Depreciation does not disappear when a property is sold.

As depreciation is claimed, it reduces the property’s tax basis. When the asset is sold:

• Previously claimed depreciation is recaptured

• Recapture is generally taxed at rates of up to 25% under current law

• Any remaining gain above the adjusted basis is typically taxed as a capital gain

Because depreciation lowers basis, recapture represents taxes owed on prior deferral rather than a simple substitution for capital gains. The value of depreciation therefore depends less on avoiding taxes entirely and more on when those taxes are paid.

Why Depreciation Can Still Be Valuable

Acknowledging recapture does not negate the benefit of depreciation.

The value of depreciation lies in time value of money:

• Taxes are deferred rather than eliminated

• Capital can be reinvested or compounded elsewhere

• The IRS effectively provides a no- or low-interest loan during the hold period

When evaluated over long horizons and across multiple investments, this deferral can materially improve after-tax outcomes even when recapture is eventually due.

Why Depreciation Is Often More Powerful Across Multiple Deals

Depreciation tends to be more impactful at the portfolio level than in a single investment.

As investors add deals over time:

• Depreciation from newer investments can offset income from stabilized properties

• Taxable income may be smoothed across years

• After-tax cash flow can become more predictable

This “laddering” effect is one reason many experienced LPs think about depreciation across multiple investments rather than deal by deal.

How Tax Considerations Fit Into Deal Evaluation

Tax benefits should not be the primary reason to invest in a deal.

They should be evaluated after assessing:

• Market and asset fundamentals

• Underwriting discipline

• Sponsor execution capability

(For deal-level context, see How to Compare Multiple Deals Side by Side.)

Tax reporting mechanics are addressed further in the K-1 Guide for New Limited Partners.

Final Perspective

Depreciation and cost segregation influence when taxes are paid, not whether value exists.

When paired with disciplined underwriting, long-term execution, and a portfolio-level perspective, these tools can meaningfully improve after-tax outcomes for passive investors – even while remaining fully taxable over time.

Note: This material is for educational purposes only and is not intended as tax, legal, or investment advice. Tax outcomes can vary significantly based on individual circumstances. Investors should consult with a qualified CPA or tax professional regarding their specific situation.

Continue Learning

This article is part of a broader learning series on passive real estate investing.

→ Start from the beginning here: Passive Real Estate Investing Learning Guide

→ Next recommended read: K-1 Guide for New Limited Partners