What if the biggest tax break in your real estate investment is also the one most likely to surprise you later?
If you're a passive investor in commercial real estate, depreciation might be one of the most valuable tools you're benefiting from without fully realizing how it works.
Depreciation and bonus depreciation can help reduce your taxable income, even while your investment is generating steady cash flow. That’s a major reason real estate syndications appeal to investors seeking strong returns with built-in tax advantages. But here’s the trade-off: when the property eventually sells, the IRS may reclaim some of those earlier tax benefits.
Whether you’re just getting started or have already received a few K-1s, this article will walk you through what depreciation actually means for you. You’ll learn how it works during the investment period, how it shows up on your tax return, and what to expect when the property is sold.
In commercial real estate, depreciation is a tax deduction that lets investors write off the cost of the building over time. It’s based on the idea that buildings wear out over time, even as the property’s market value increases.
For retail centers and other commercial properties, the IRS allows the building (not the land) to be depreciated over 39 years. That results in a steady annual deduction that reduces your share of taxable income.
Let’s say a shopping center is purchased for $5 million, with $1 million allocated to land. The remaining $4 million can be depreciated over 39 years, resulting in about $102,564 per year.
Even as a passive investor, you’ll benefit from this deduction. Your share of the depreciation will be included in your annual K-1, which often reduces or completely eliminates your tax liability on the income the property generates.
Bonus depreciation takes things a step further. Instead of spreading out deductions over many years, bonus depreciation lets you deduct a large portion of certain costs right away in the first year they’re incurred.
This applies to assets with a useful life of 20 years or less. That includes items such as lighting, appliances, equipment, or improvements made for tenants. After the 2017 Tax Cuts and Jobs Act, investors could deduct 100 percent of these costs in the first year. That benefit is now being phased out.
Bonus Depreciation Phase-Out Schedule
If the sponsor of your investment spends $500,000 on qualified improvements in 2024, they could deduct $300,000 that same year under the current 60 percent rule. That deduction flows through to investors via the K-1.
This can lead to a paper loss in the first year, even if the investment is generating income and sending out distributions. That is one of the tax-efficient features many real estate investors look for, especially in the early years of ownership.
The tax savings from depreciation are helpful while you hold the investment, but they don’t last forever. When the property is sold, the IRS will want to recapture the depreciation you claimed. This is called depreciation recapture.
Here’s why: each year of depreciation reduces your cost basis in the property. That means when the property sells, the taxable gain appears larger. The IRS treats the portion of the gain that came from depreciation differently from regular capital gains. Think of it like borrowing a tax break up front. When the property sells, the IRS comes back to collect on what you borrowed, often at a higher interest rate, up to 25 percent.
Let’s say you received $40,000 in depreciation over several years. When the property sells, you may owe tax on that $40,000 at the depreciation recapture rate. This will be reflected on your final K-1 from the fund or syndication.
Even though you’re not the one managing the sale, you’re still responsible for your share of the outcome. That is why understanding how depreciation recapture works and when it applies is so important.
Most passive investors participate in shopping center deals through funds or syndications. These are structured so that investors don’t have to worry about day-to-day decisions, but they still receive the tax benefits and responsibilities through annual K-1s.
Here’s what you can generally expect:
Even though you’re not directly selling anything, you are still a fractional owner in the eyes of the IRS. Your tax obligations reflect that.
If the sponsor plans to do a 1031 exchange, refinance, or take a different exit path, it may affect how and when you pay taxes. This is why asking about the business plan upfront and understanding how exits are structured can help you plan more effectively.
Depreciation is a key factor that makes real estate so tax-friendly. It can shield income during the investment’s life and help make returns more tax-efficient, especially when combined with strategies like bonus depreciation.
But here’s the flip side: what helps you during the hold period can come back into play when the investment exits. Depreciation recapture can increase your tax bill in the year of sale, so it is not something to overlook.
Here’s what it means in practical terms:
Understanding how all of this works, even at a basic level, makes you a more informed investor. It helps you evaluate the tax impact of a deal and ask better questions upfront, before committing capital.
If you want to go deeper, the RockStep Learning Center is packed with straightforward guides, visuals, and real-world examples to help you build confidence at every stage of your investing journey. And if you want a look behind the scenes at how shopping centers are actually run, redeveloped, and improved over time, check out The Shopping Center Channel on YouTube.
Depreciation is one of the few ways real estate lets you earn income and report a loss on paper. This is not a loophole. It is a built-in advantage. And if you are a passive investor, this tax shield can quietly boost your returns year after year without any extra work on your part.
However, what you deduct today may be taxed later. When the investment ends, the IRS will recapture those benefits, and you need to be prepared. Understanding how depreciation and bonus depreciation flow through your K-1, and what happens when a property is sold, is not just smart. It is essential.
You do not need to be a tax expert. You just need to know what to expect and work with people who plan ahead. In real estate, staying informed is how you stay ahead.