Cost Recovery in Real Estate: MACRS, Bonus Depreciation, and Recapture

Real estate depreciation rules let you deduct the cost of an income-producing building over a fixed number of years: 27.5 years for residential rental property and 39 years for commercial property, using straight-line recovery under the Modified Accelerated Cost Recovery System (MACRS).¹ Only the structure depreciates; the land underneath it never does.² Within that framework, cost segregation studies, first-year bonus depreciation, and Section 179 elections can pull large deductions forward, while passive activity limits and depreciation recapture at sale set the ceiling on how much benefit you actually keep.

Setting Your Depreciable Basis

Every calculation starts with cost basis. For a purchased property, that is the price you paid plus acquisition costs like legal fees, surveys, title insurance, and transfer taxes. Before anything gets depreciated, you have to separate the land value from the building value, because land is treated as having no determinable useful life.² Most investors use the local property tax assessor’s ratio between land and improvements, or hire an independent appraiser. Leaning on the seller’s allocation without documentation is the kind of shortcut that invites an IRS challenge.

Basis is not static. It decreases each year by the depreciation you claim on Form 4562, and it increases whenever you make capitalized improvements, like replacing an entire roof or adding square footage.³ That adjusted basis is what determines your gain when you eventually sell, so accurate tracking matters from day one.

Inherited Property Resets the Clock

If you inherit a property instead of buying it, the cost basis resets to the fair market value on the date of the decedent’s death.⁴ The prior owner’s accumulated depreciation and unrealized appreciation are erased. If you place the inherited property into rental service, the stepped-up value (minus land) becomes your new depreciable basis, and a fresh 27.5- or 39-year schedule begins.

How the MACRS Schedule Works

Nearly all income-producing real estate placed in service after 1986 falls under MACRS.⁵ For buildings, MACRS requires straight-line recovery, meaning the depreciable basis is spread evenly across a fixed recovery period:

Residential rental property depreciates over 27.5 years. A building qualifies as residential rental when 80% or more of the gross rental income comes from dwelling units.¹
Nonresidential real property depreciates over 39 years. Office buildings, retail spaces, warehouses, and any income-producing structure that misses the 80% residential threshold sit here.¹

The recovery periods are set by statute. A 60-year-old building in rough shape still depreciates over 27.5 or 39 years, regardless of its actual remaining physical life.

First-year and disposition-year calculations use the mid-month convention. The IRS treats property as placed in service at the middle of whatever month you started using it, so closing on a rental in March gives you 9.5 months of depreciation that first year, not a full 12.¹ The same logic applies in the year of sale.

Accelerating Deductions With Cost Segregation

Straight-line recovery over 27.5 or 39 years is slow. A cost segregation study is an engineering-based analysis that breaks a building into its individual components and reclassifies certain items out of the long building schedule into shorter MACRS lives:

5-year or 7-year property: specialized plumbing, dedicated electrical wiring, decorative fixtures, carpeting, and certain equipment built into the structure.
15-year property: land improvements like sidewalks, parking lots, fencing, and landscaping.²

The study requires an engineer or specialized firm to physically inspect the property, measure and cost out qualifying components, and produce a detailed report that can withstand IRS scrutiny. If the property is already in service, applying the results counts as a change in accounting method, which means filing Form 3115.⁶ The adjustment is applied retroactively as a one-time catch-up deduction in the year of the change; no amended returns required.

Cost segregation typically pencils out for properties with a cost basis above roughly $1 million, though there is no formal threshold. Where the numbers really move is in combination with bonus depreciation.

Bonus Depreciation Under Current Law

Bonus depreciation lets you deduct a percentage of a qualifying asset’s cost in the first year it is placed in service, rather than spreading it over the normal MACRS schedule. The One Big Beautiful Bill Act, signed in July 2025, permanently restored 100% bonus depreciation for qualifying property acquired after January 19, 2025.⁷ The 5-year, 7-year, and 15-year property identified by a cost segregation study can be fully expensed in year one.

The math gets dramatic quickly. If an engineer reclassifies $400,000 of a $1.5 million building as short-lived personal property and land improvements, that $400,000 comes off in year one instead of trickling out over decades. Depending on your situation, the result can be a paper loss large enough to offset income from other activities, subject to the passive loss rules below.

Bonus depreciation is automatic. Place qualifying property in service and the 100% deduction applies unless you affirmatively elect out. The election is made on a class-by-class basis, not selectively within a class.

Section 179 Expensing on Building Components

Section 179 is a separate immediate-expensing option with its own rules. It lets you elect to expense the cost of qualifying property up to an annual dollar limit. For tax years beginning in 2026, the maximum deduction is $2,560,000, phasing out dollar-for-dollar once total qualifying property placed in service exceeds $4,090,000.⁸

For real estate, Section 179 applies to qualified real property: roofs, heating and air conditioning systems, fire protection and alarm systems, and security systems placed in service after the building itself was placed in service.² The key limitation is that Section 179 cannot create or increase a net business loss. Unused deductions carry forward until you have enough income to absorb them. Bonus depreciation has no such income limit, which is why most investors reach for it first.

Repairs Versus Improvements

Once a property is in service, spending on it raises a recurring question: deduct now as a repair, or capitalize and depreciate over 27.5 or 39 years? The IRS Tangible Property Regulations set the line.⁹

A repair keeps the property in its current working condition without materially adding to its value or extending its life. Patching a section of roof, fixing a broken window, or repainting a unit are repairs. An improvement adds value, extends useful life, or adapts the property to a new use. Replacing an entire roof, installing a new HVAC system, or gutting and renovating a floor are improvements that get capitalized.

Two safe harbors simplify borderline cases:

De minimis safe harbor. Taxpayers with an applicable financial statement can expense items costing $5,000 or less per invoice. Without one (which is most individual landlords), the threshold is $2,500 per invoice.⁹
Routine maintenance safe harbor. Costs for activities you reasonably expect to perform more than once during the property’s MACRS recovery period, such as regular HVAC servicing or scheduled repainting, can be deducted.

Both require an annual election on the return. Miss the election that year and you lose the benefit; there is no retroactive fix.

Can You Actually Use the Losses?

Large depreciation deductions look powerful on paper, but the passive activity rules control whether you get to use them against other income. Rental real estate is generally passive, meaning losses can only offset other passive income, not wages, business profits, or investment gains.¹⁰ Unused passive losses carry forward and can be applied against future passive income or released entirely when you sell.

Two exceptions matter. The first is the $25,000 special allowance. If you actively participate in managing the rental (making real decisions about tenants, repairs, and lease terms rather than handing everything to a management company), you can deduct up to $25,000 of rental losses against non-passive income each year.¹⁰ That allowance phases out by 50 cents per dollar of modified AGI above $100,000 and disappears at $150,000.

The second is real estate professional status. Spend more than 750 hours a year in real property trades or businesses, with that work accounting for more than half of your total personal services, and your rental activities stop being automatically passive. You still have to materially participate in each rental (or group them by written election and meet the participation test at the group level). Qualifying strips away the passive limitation entirely, so cost-segregation-driven losses can offset any income.

What Happens When You Sell

Every dollar of depreciation you claim reduces basis, which increases the taxable gain at sale. When you sell for more than your adjusted basis, the portion of the gain attributable to depreciation you took (or were allowed to take, even if you skipped it) is unrecaptured Section 1250 gain, taxed at a maximum rate of 25%.¹¹ Any gain above the original cost basis is taxed at long-term capital gains rates.

Accelerating depreciation through cost segregation and bonus depreciation does not change the total recapture; it changes the timing. Larger deductions upfront produce a correspondingly larger recapture bill at sale. Most investors treat that as a favorable trade because a dollar of tax deferred is worth more than a dollar of tax paid now. Recapture is not optional either. Even if you forgot to claim depreciation in some years, the IRS calculates recapture on what you were entitled to claim.

Deferring Recapture With a 1031 Exchange

A like-kind exchange under Section 1031 lets you sell one investment property and reinvest into another without paying tax on the gain, including the recapture that would otherwise be due.¹² Both the property you sell and the replacement must be held for business use or investment. Personal residences and vacation homes do not qualify.¹³

The definition of like-kind for real estate is broad. An apartment building can be exchanged for vacant land, a warehouse for an office, or a strip center for a single-family rental. U.S. real estate cannot be exchanged for real estate outside the country.

The deadlines are strict and cannot be extended for hardship. You have 45 days from the sale of the relinquished property to identify potential replacements in writing, and the exchange must close within 180 days of the sale, or by the due date of your return including extensions, whichever comes first.¹² Miss either deadline and the full gain becomes taxable.

If you take cash or non-like-kind property out of the exchange (boot), that portion is taxable immediately and is treated as depreciation recapture first, up to the amount of accumulated depreciation, with any excess as capital gain. Cleanest results come from reinvesting all proceeds and matching or exceeding the debt on the relinquished property.

A 1031 exchange defers recapture; it does not erase it. Your basis in the new property carries over from the old, preserving the built-in gain. Some investors chain exchanges throughout their careers and never trigger recapture, eventually passing the property to heirs who receive a stepped-up basis that clears both the deferred gain and the accumulated depreciation.⁴

1
Office of the Law Revision Counsel. 26 U.S. Code 168 – Accelerated Cost Recovery System
2
Internal Revenue Service. Topic No. 704 Depreciation
3
Internal Revenue Service. About Form 4562, Depreciation and Amortization
4
Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent
5
Internal Revenue Service. Publication 946 – How To Depreciate Property
6
Internal Revenue Service. Instructions for Form 3115 – Application for Change in Accounting Method
7
Internal Revenue Service. Additional First Year Depreciation Deduction (Bonus) – FAQ
8
Office of the Law Revision Counsel. 26 U.S. Code 179 – Election to Expense Certain Depreciable Business Assets
9
Internal Revenue Service. Tangible Property Regulations – Frequently Asked Questions
10
Office of the Law Revision Counsel. 26 U.S. Code 469 – Passive Activity Losses and Credits Limited
11
Internal Revenue Service. Publication 544 – Sales and Other Dispositions of Assets
12
Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment
13
Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031