Depreciation is a powerful tool that enables real estate investors to reduce taxable income by accounting for the wear and tear on their properties over time. For net lease investors, leveraging depreciation can be especially valuable, as it allows them to boost cash flow and maximize investment returns. Knowing the various types of depreciation and how they apply to net lease investments is key to making the most of these tax benefits.

What is depreciation in real estate?

Depreciation is the process by which the IRS allows property owners to deduct the cost of their buildings over a period of time, reflecting the natural decline in value due to use, wear, and tear. For net lease investors, where tenants typically handle most property expenses, depreciation provides an essential tax shield that reduces taxable income. The IRS categorizes depreciation schedules for real estate as follows: 27.5 years for residential properties and 39 years for commercial properties, including net lease investments.

Types of depreciation for net lease investors

There are multiple types of depreciation that net lease investors can use to reduce their taxable income:

Straight-line depreciation

Straight-line depreciation is the most common method used in real estate. It allows property owners to deduct an equal amount of the building’s cost yearly over its useful life — 39 years for commercial properties. In net lease investments, this means that each year, an investor can deduct a portion of the property’s cost from their taxable income, lowering their overall tax burden. While this method provides consistent deductions, other options offer more significant benefits upfront.

Section 179 deduction

The Section 179 deduction allows certain property improvements or personal property components to be fully deducted in the first year they are placed into service. While traditionally used in business assets like equipment, real estate investors can apply Section 179 to tangible personal property improvements within their buildings, such as HVAC systems or interior upgrades. There are limits on the amount that can be deducted under Section 179, but this method provides a way to accelerate tax savings in the first year of ownership.

Bonus depreciation

Bonus depreciation is a method that allows investors to write off a large percentage of the cost of qualifying assets in the first year of ownership. Recent changes under the Tax Cuts and Jobs Act (TCJA) expanded bonus depreciation, allowing investors to deduct 100% of the cost of qualifying assets, including used properties, through 2022. While the percentage deduction may decline in future years, bonus depreciation remains a valuable tool for net lease investors who want to minimize taxable income quickly.

Accelerated depreciation through cost segregation

Cost segregation is another powerful depreciation strategy that allows investors to break down a property into its individual components, many of which can be depreciated faster than the standard 39-year schedule for commercial buildings. Items like electrical systems, plumbing, and HVAC can often be depreciated over 5, 7, or 15 years instead of the longer schedule for the building structure itself.

A cost segregation study by specialized accountants or engineers identifies these components and assigns them shorter depreciation lives. This strategy accelerates depreciation, allowing net lease investors to capture tax deductions earlier in the property’s lifecycle, improving cash flow in the early years of ownership.

Accelerated depreciation for fuel-oriented properties

Fuel-related properties like gas stations, convenience stores (e.g., 7-Eleven), Jiffy Lube, and wholesale gas distributors can take advantage of accelerated depreciation due to the specialized nature of their assets. Equipment such as fuel dispensers, underground storage tanks, and specific infrastructure components often qualify for shorter depreciation schedules, typically 5 to 15 years.

This allows investors to depreciate these assets more quickly, reducing taxable income in the initial years and boosting net income early in the investment. The faster depreciation recovery can significantly enhance cash flow, especially for properties with high infrastructure costs. A cost segregation study helps identify these components, ensuring they are correctly classified for accelerated depreciation.

By leveraging these deductions early on, investors can maximize returns and reinvest tax savings into future projects. Working with tax professionals ensures compliance and accurate application of these benefits for fuel-related properties.

Implementing cost segregation in net lease investments

Cost segregation can significantly boost tax savings, but it requires careful planning. A cost segregation study analyzes the building and identifies the various components eligible for accelerated depreciation. For net lease investors, this can result in considerable tax deductions in the first few years after purchasing or improving a property. Investors can reduce taxable income by accelerating depreciation on shorter-lived assets and reinvesting those savings into their portfolios, increasing overall returns.

For example, suppose an investor purchases a $1 million net lease property. In that case, a cost segregation study may determine that $300,000 of the property comprises shorter-lived assets like fixtures or land improvements, which can be depreciated over 5 to 15 years instead of 39 years. This faster depreciation results in larger deductions in the early years, providing substantial tax relief and boosting cash flow.

Depreciation recapture: what investors need to know

While depreciation provides significant tax benefits during property ownership, investors need to be mindful of depreciation recapture when the property is sold. Depreciation recapture occurs when the IRS reclaims a portion of the tax benefits received from depreciation deductions by taxing the gain on the sale of the property at a higher rate.

For net lease investors, depreciation recapture can significantly reduce the profits from a sale if not properly planned for. One way to minimize or defer depreciation recapture is through a 1031 exchange, where the investor reinvests the proceeds from the sale into a new property, deferring capital gains and depreciation recapture taxes.

Impact of depreciation on taxable income and cash flow

Depreciation reduces taxable income, boosting cash flow by lowering the amount of taxes owed. Since depreciation is a non-cash expense, investors don’t have to pay out-of-pocket for the deduction, yet it directly reduces the income on which they pay taxes.

For example, if an investor generates $100,000 in rental income from a net lease property and can claim $30,000 in depreciation deductions, their taxable income drops to $70,000, significantly reducing their tax liability. This tax shield increases the property’s overall return on investment by boosting after-tax cash flow.
 
Key considerations for net lease investors

Property qualification: Not all properties or assets qualify for bonus or accelerated depreciation. Investors must ensure that their properties meet IRS requirements and properly allocate costs to avoid challenges during audits.

Working with professionals: Maximizing the benefits of depreciation, particularly strategies like cost segregation and bonus depreciation, requires expertise. Consulting with tax professionals specializing in real estate ensures that investors can optimize their tax strategies while remaining compliant with IRS regulations.
 
Common mistakes to avoid

Misclassifying assets: Improperly categorizing assets for accelerated depreciation can lead to IRS scrutiny. Ensuring that a qualified professional conducts a cost segregation study minimizes the risk of misclassification.

Overlooking bonus depreciation or Section 179: Missing out on opportunities for bonus depreciation or Section 179 deductions can mean leaving significant tax savings on the table. Investors should review these options during property acquisition or renovation to maximize their deductions.

Failing to plan for depreciation recapture: Depreciation recapture can erode profits on the sale of a property if not planned for. Investors should consider strategies like a 1031 exchange to defer these taxes and protect their gains.
 
Building a more robust portfolio

Depreciation is one of the most effective tools for net lease investors to reduce taxable income and maximize returns. Investors can substantially improve their cash flow and investment outcomes by understanding and leveraging strategies like straight-line depreciation, bonus depreciation, Section 179 deductions, and accelerated depreciation through cost segregation.

Working with tax professionals and planning for future tax events like depreciation recapture ensures that investors can fully benefit from these tax strategies while staying compliant with the IRS. Properly leveraging depreciation can enhance long-term success and help investors build a more robust, tax-efficient portfolio.