Depreciation — The Biggest Tax Benefit You Already Have

Residential rental property depreciates over 27.5 years. Commercial property over 39 years. On a $1.5 million LA duplex (with $400,000 allocated to land), you’re looking at roughly $40,000 per year in depreciation deductions — a paper loss that reduces your taxable rental income even though you didn’t spend a dime.

But here’s where it gets interesting. A cost segregation study can accelerate depreciation by reclassifying components of the building — appliances, flooring, cabinetry, landscaping, parking lots, electrical systems — into shorter-lived asset classes (5, 7, or 15 years instead of 27.5 or 39). On a $3 million apartment building, a cost segregation study might generate $300,000 to $500,000 in first-year depreciation deductions. That’s real tax savings in year one.

Bonus depreciation at 60% for 2024 applies to those reclassified components. It’s phasing down — 40% in 2025, 20% in 2026, gone in 2027 — so the window to capture the biggest benefit is closing. If you’ve acquired property in the last few years and haven’t done a cost seg study, you’re leaving money on the table.

1031 Exchanges in a High-Value Market

A 1031 exchange lets you defer capital gains tax when you sell an investment property and reinvest the proceeds into a “like-kind” replacement property. In LA, where appreciation has been enormous, the deferred gains can be massive. Sell a $2 million property you bought for $800,000 and you’re deferring tax on $1.2 million in gains. At federal and California combined rates, that’s $300,000 or more in taxes you don’t pay — yet.

The timelines are strict. You have 45 days from closing to identify replacement properties and 180 days to close on one. Miss either deadline and the exchange fails — the entire gain becomes taxable. We’ve seen investors lose six-figure tax deferrals because they couldn’t find a replacement property in time and didn’t understand the identification rules (you can identify up to three properties, or more under the 200% rule).

California taxes 1031 exchange gains if you eventually sell the replacement property — the state tracks deferred gains with Form 593 and FTB 3840. If you do a 1031 exchange in California and buy replacement property in Nevada (a no-income-tax state), California still wants its cut of the original deferred gain when you eventually sell. They call it a “clawback” and they enforce it.

Passive Activity Rules and Real Estate Professional Status

Rental income is passive by default. That means your rental losses can only offset other passive income — not your W-2 salary or business income. For high-income investors, those losses just pile up unused, waiting for a disposition event.

The exception: Real Estate Professional Status (REPS) under IRC Section 469(c)(7). If you spend more than 750 hours per year in real estate activities and more than half your working time is in real estate, your rental losses become non-passive. A $200,000 depreciation loss from a cost segregation study can now offset your spouse’s $300,000 salary. That’s a $70,000+ tax refund in some cases.

The IRS audits REPS claims aggressively. You need a contemporaneous time log — not a reconstruction after the fact. The activities that count are specific: property management, renovations, tenant negotiations, property inspections, reviewing financials. Driving by your property doesn’t count. We help LA investors set up documentation systems that hold up on audit.

LA Rent Stabilization and Tax Implications

If you own rental property built before October 1978 in the city of LA, it’s probably subject to the Rent Stabilization Ordinance (RSO). That affects your tax situation in a few ways. First, the RSO registration fees you pay to LAHD ($43.32 per unit annually) are deductible as a business expense. Second, the rent increases you’re allowed to charge are capped — which affects your income projections for estimated tax payments.

The Ellis Act allows landlords to withdraw units from the rental market, but there are relocation assistance payments required ($8,450 to $21,200 per tenant depending on circumstances). Those payments are deductible business expenses, and they’re substantial enough to affect your tax picture in the year you make them.

Property Tax Under Proposition 13

Prop 13 limits property tax to 1% of the assessed value at purchase, with annual increases capped at 2%. That’s great if you’ve owned an LA property for 20 years — your tax bill is a fraction of what a new buyer would pay. But every transfer triggers a reassessment to current market value.

Proposition 19 (effective 2021) eliminated the parent-to-child exclusion for investment properties. Before Prop 19, you could inherit your parents’ rental property and keep their low Prop 13 assessed value. Now, inherited investment properties get reassessed to market value. For an LA rental property with a $200,000 assessed value and a $1.5 million market value, that’s a property tax increase from $2,000 to $15,000 per year. Estate planning for LA real estate investors changed dramatically after this law passed.