Depreciation is one of the most misunderstood—and most powerful—features of real estate investing. For investors in real estate funds, depreciation can significantly reduce taxable income without reducing cash flow, making it a core driver of after-tax returns.

Yet many limited partners don’t fully understand how depreciation is calculated, how it flows through a fund structure, or why two investors in the same fund might experience different tax outcomes. This article explains how depreciation actually works in real estate funds, from acquisition through exit, in plain language but with institutional-level accuracy.

What Depreciation Really Is (and Isn’t)

Depreciation is a non-cash accounting expense that allows property owners to deduct the cost of a building over its useful life, as defined by the IRS. Residential real estate is typically depreciated over 27.5 years, while commercial real estate uses a 39-year schedule.

The key distinction is that depreciation does not reflect actual economic decline. In many cases, the property may be increasing in value even as depreciation deductions are taken. For investors, this disconnect between accounting treatment and economic reality is where the advantage lies.

In a real estate fund, depreciation reduces the fund’s taxable income, even though the fund may still be generating strong cash flow.

How Depreciation Enters a Real Estate Fund

When a fund acquires a property, the purchase price is allocated between land and improvements. Land is not depreciable. The building and certain improvements are.

Once this allocation is established, the fund begins depreciating the building portion annually. That depreciation flows through the fund’s pass-through structure to individual investors, reducing their share of taxable income.

Importantly, depreciation does not depend on leverage. Whether the fund uses 50% debt or 70% debt, depreciation is based on the property’s value, not the equity invested. This is one reason real estate funds can produce tax-efficient returns even when using conservative leverage.

Pass-Through Taxation: How Investors Receive Depreciation

Most real estate funds are structured as pass-through entities, typically LLCs or limited partnerships. This means the fund itself does not pay income tax. Instead, profits, losses, and depreciation are allocated to investors based on the partnership agreement.

Each investor receives a Schedule K-1, which reports their share of income, expenses, and depreciation. The depreciation allocated to you may offset some or all of the income distributed by the fund.

This is why investors often receive cash distributions while reporting little or no taxable income from the investment.

Cost Segregation Inside Real Estate Funds

Basic depreciation spreads deductions evenly over decades. Cost segregation accelerates this process.

Through a cost segregation study, certain components of a property—such as electrical systems, plumbing, flooring, and site improvements—are reclassified into shorter depreciation lives. This allows a larger portion of the property’s value to be depreciated in the early years of ownership.

In real estate funds, cost segregation is often applied at the fund level shortly after acquisition. The resulting accelerated depreciation is then allocated to investors according to the partnership agreement.

This front-loaded depreciation can dramatically increase early-year tax sheltering, which is especially valuable for investors with significant taxable income elsewhere.

Why Depreciation Often Exceeds Cash Flow

A common point of confusion for new investors is how depreciation can exceed actual cash flow. The reason lies in the difference between accounting income and economic income.

Cash flow is calculated after operating expenses and debt service. Depreciation is calculated on the building’s value and does not reflect loan payments or capital expenditures.

As a result, it’s common for a real estate fund to distribute cash while reporting a tax loss due to depreciation. This is not a loophole—it’s a core feature of the tax code designed to encourage investment in real assets.

Passive Activity Rules and Investor Eligibility

Depreciation losses from real estate funds are generally considered passive losses. For most investors, passive losses can only offset passive income, not active income like wages or business income.

However, there are important exceptions. Investors who qualify as real estate professionals or who meet certain income thresholds may be able to use depreciation to offset non-passive income.

Even when losses cannot be used immediately, they are not lost. Suspended passive losses carry forward and can be used in future years or upon the sale of the investment.

Depreciation at the Fund Level vs Individual Ownership

One advantage of fund investing is scale. Larger properties often justify more sophisticated depreciation strategies, including detailed cost segregation studies that would not be economical for smaller properties.

Additionally, professional fund managers typically optimize depreciation timing and allocation as part of their overall tax strategy. This can result in more efficient outcomes than individual investors attempting to manage depreciation on their own.

What Happens to Depreciation at Exit

Depreciation is not free money—it is tax deferral, not tax elimination.

When a property is sold, some portion of the depreciation taken may be subject to depreciation recapture, which is taxed at a different rate than long-term capital gains. However, even after accounting for recapture, the time value of money often makes depreciation highly advantageous.

Funds may also use 1031 exchanges to defer taxes entirely by reinvesting proceeds into new properties, allowing depreciation benefits to continue compounding.

Why Depreciation Matters More in Funds Than Investors Realize

For many limited partners, depreciation is the difference between a good investment and a great one. Two funds with similar pre-tax returns can deliver very different after-tax outcomes depending on how depreciation is managed.

Investors who ignore depreciation are effectively comparing investments using incomplete information.

Who Benefits Most From Depreciation in Real Estate Funds

Depreciation is most valuable for investors with current or future taxable income to offset. High-earning professionals, business owners, and accredited investors often find that depreciation materially improves portfolio efficiency.

Investors focused on long-term wealth preservation and after-tax returns—not just headline IRRs—tend to benefit most from real estate funds that prioritize tax efficiency.

Conclusion: Depreciation Is a Feature, Not a Footnote

Depreciation is not an accounting technicality—it is a foundational reason real estate funds remain attractive to sophisticated investors. By reducing taxable income without reducing cash flow, depreciation enhances after-tax returns and improves capital efficiency.

Understanding how depreciation works allows investors to evaluate funds more intelligently, ask better questions, and make decisions based on what truly matters: what you keep after taxes.