Depreciation remains one of the most powerful incentives available to real estate investors and business owners. It reduces taxable income, strengthens cash flow, and when applied strategically, it can accelerate deductions into the years when they matter most. With the passage of the One Big Beautiful Bill Act (2025), the landscape has shifted again, restoring 100% bonus depreciation and dramatically increasing Section 179 limits.
This guide provides a clear, investor focused overview of accelerated depreciation, Section 179 expensing, and the critical interaction between depreciation and 1031 exchanges, all rooted in IRS Publication 946 and current tax law.
Depreciation allows taxpayers to recover the cost of business or income producing property over time. Under IRS Publication 946, depreciable property must:
• Be owned by the taxpayer
• Be used in a trade or business or for income production
• Have a determinable useful life
• Last more than one year
Real estate is depreciated over long periods (27.5 or 39 years), but many of the individual building and land improvement components qualify for much shorter lives, also known as accelerated deductions, achieved through cost segregation.
Under MACRS (Modified Accelerated Cost Recovery System), certain assets qualify for shorter recovery periods:
5-Year Property:
• Appliances
• Dedicated electrical systems
• Removable flooring
• Equipment and machinery
15-Year Property
• Parking lots and paving
• Sidewalks and curbs
• Landscaping
• Site utilities
Cost segregation studies reclassify these components out of 39-year property and into shorter-lived categories, dramatically accelerating deductions.
With OBBBA restoring 100% bonus depreciation, nearly all 5 and 15year property can be expensed immediately.
Section 179 allows businesses to immediately expense qualifying property in the year placed in service. OBBBA significantly increased these limits.
2025 Section 179 Limits (Post OBBBA)
• Maximum deduction: $2,500,000
• Phaseout threshold: $4,000,000
• Complete phaseout: $6,500,000
2026 Section 179 Limits (Inflation Adjusted)
• Maximum deduction: $2,560,000
• Phaseout threshold: $4,090,000
• Complete phaseout: $6,650,000
What Qualifies
• Tangible personal property
• Certain nonresidential building improvements
• Off the shelf software
• Heavy vehicles and equipment
Real property itself does not qualify, but many improvements do.
Section 179 remains elective and subject to income limitations, while bonus depreciation applies automatically unless you opt out.
Depreciation recapture is the tax paid when previously claimed depreciation is “recaptured” as income upon sale or disposition. The rules differ depending on whether the asset is:
• Section 1245 property (personal property, land improvements, and any asset with accelerated depreciation)
• Section 1250 property (real property depreciated using straight line methods)
Cost segregation increases the amount of Section 1245 property, which increases potential recapture.
Below are three scenarios using the same property to illustrate how depreciation method affects recapture and 1031 exchange outcomes.
Scenario Setup (Used for All Examples)
• Purchase price: $1,000,000 (excluding land)
• Cost segregation identifies $200,000 of 5 and 15year assets (Section 1245)
• Remaining $800,000 is 39year Section 1250 property
• Property sold after 5 years for $1,200,000
1. Straight-line Depreciation Only (No Cost Segregation)
Depreciation Taken
• Annual deprecation = $1,000,000/39 = $25,641 or $128,205 in 5-years
Recapture
• No Section 1245 property → no ordinary income recapture
• Section 1250 unrecaptured gain taxed at 25% $128,205 X 25% = 32,051
1031 Exchange Treatment
A properly executed 1031 exchange defers all Section 1250 recapture.
No special matching of 1245 property is required because none exists.
2. Cost Segregation Without Bonus Depreciation
Depreciation Taken
• 5year property ($150,000): nearly fully depreciated → $150,000
• 15year property ($50,000): ≈ 33% depreciated → $16,500
• 39year property: $800,000/39 X 5 = 102,564
Total depreciation: $150,000 + $16,500 + $102,564 = $269,064
Recapture
• Section 1245 recapture: $166,500 taxed at ordinary income rates
• Section 1250 recapture:
$102,564 X 25% = $25,641
1031 Exchange Treatment
Section 1245 property must be replaced with equal or greater Section 1245 property to avoid recapture.
Example:
• Relinquished property: $200,000 of 1245 property
• Replacement property: $120,000 of 1245 property
Ordinary income recapture: $200,000 - $120,000 = $80,000
This tax is not deferred, even inside a 1031 exchange.
3. Cost Segregation With 100% Bonus Depreciation
Depreciation Taken
• 1245 property: $200,000 deducted in year 1
• 1250 property: $800,000 / 39 X 5 = $102,564
Total depreciation: $200,000 + $102,564 = $302,564
Recapture
• Section 1245 recapture: $200,000 taxed at ordinary income rates
• Section 1250 recapture: $102,564 X 25% = $25,641
Bonus depreciation maximizes early years’ cash flow but also maximizes potential recapture.
1031 Exchange Treatment
Same rule: 1245 property must be replaced with equal or greater 1245 property.
Example:
• Relinquished property: $200,000 of 1245 property
• Replacement property: $150,000 of 1245 property
Ordinary income recapture: $200,000 - $150,000 = $50,000
This tax is not deferred.
|
Scenario |
Total Depreciation |
1245 Recapture (Ordinary Income) |
1250 Recapture (25%) |
1031 Exchange Exposure |
|
Straight line only |
$128,205 |
$0 |
$128,205 × 25% |
Fully deferrable |
|
Cost seg, no bonus |
$269,064 |
$166,500 |
$102,564 × 25% |
Must replace 1245 property |
|
Cost seg + bonus |
$302,564 |
$200,000 |
$102,564 × 25% |
Highest 1245 replacement requirement |
OBBBA restored 100% bonus depreciation, making cost segregation more powerful than ever.
Section 179 limits have doubled, offering even more upfront expensing capacity.
Cost segregation increases early cash flow but also increases Section 1245 recapture exposure.
A 1031 exchange does not automatically defer 1245 recapture—you must replace 1245 property with equal or greater 1245 property.
Performing a cost segregation study on the replacement property is often essential to avoid recapture.
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