Depreciation: An Introduction for Private Real Estate Investors

Many high-net-worth private real estate investors may owe hundreds of thousands of dollars in taxes per year.

That’s why the tax efficiency of a private real estate investment fund—its ability to defer or reduce taxes—is arguably just as important as the fund’s headline return.**

While stocks and bonds generate income that is often immediately taxable, some private real estate equity funds, such as the DLP Housing Fund, can potentially allow investors to shield income from taxation through depreciation.**

Understanding the basics of depreciation

At its core, depreciation in real estate is an income tax deduction that allows investors to recover the cost of a property over time due to expected wear, tear, and obsolescence.¹ For tax purposes, the IRS assumes that buildings lose value as they age.

To calculate this, an investor typically subtracts the land value (which is not depreciable) from the property’s cost basis and divides the remaining building value by the IRS recovery period. Residential properties, like attainable multifamily housing communities, are deemed to have a useful life of 27.5 years.¹

This means that a multifamily community purchased for $50 million with a land basis of $10 million can be depreciated at a rate of ($50 million - $10 million) / 27.5 years = $1.45 million per year.

This annual depreciation deduction reduces taxable income without affecting the actual cash flow generated by the property. When the property is held within a private real estate fund, the benefits of depreciation can be passed on to the fund’s passive investors, though tax treatment depends on the fund’s structure. In a REIT structure, for example, depreciation may reduce taxable income at the entity level, which can cause a portion of investor distributions to be characterized as a return of capital rather than as taxable dividends.

To be clear, only certain elements of a property qualify for accelerated depreciation. A property’s land basis, for example, is not depreciable. Other structural components must be depreciated over the full 27.5 years. Still, cost segregation studies are beneficial because they can potentially identify qualifying components that may be eligible for shorter recovery periods and, where applicable, bonus depreciation.

Recall the example above. Under standard rules, a $50 million property with $10 million in land basis (i.e. $40 million in depreciable basis) yields a little over $1 million in annual depreciation deductions. If a cost segregation study is performed, that same property could potentially generate several million dollars in depreciation deductions in the first year alone.

Keeping more of what you earn with REITs

Accelerated depreciation is powerful on its own, but its benefits are supercharged when the investment is structured as a Real Estate Investment Trust (REIT), like the DLP Housing Fund.

In this structure, the depreciation we calculated earlier doesn’t just sit on a balance sheet—it “flows up” to shelter the fund’s income. This creates two distinct tax advantages for investors: tax-deferred cash flow today and lower tax rates tomorrow.

1. Tax-deferred income

Because depreciation is a non-cash expense, it can technically lower the fund’s taxable income to zero (or close to it), even while the properties are generating real cash. This means that the monthly preferred distributions investors in the DLP Housing Fund receive aren’t treated as taxable dividends. Instead, they are often classified as a return of capital.

For tax purposes, a return of capital is treated as a tax-free reimbursement of your original investment, rather than as taxable income. Through 2024, distributions from the DLP Housing Fund have been characterized this way—meaning investors have historically received cash flow without an immediate annual tax bill.*

2. Lower taxes on exit

REIT structures do not eliminate taxes. Instead, taxation is deferred until investors redeem their fund shares. However, this tax deferral comes with an advantage: rate conversion.

Earlier distributions, which were treated as a return of capital, lower an investor’s cost basis. Provided the REIT shares or units are held for over one year, the difference between an investor’s lowered basis and their exit price is typically taxed at more favorable capital gain tax rates upon redemption, rather than at higher ordinary income rates.³

To be clear, tax deferral only lasts while the investor’s cost basis remains above zero; once depleted, subsequent distributions are taxed immediately.⁴ Finally, while direct share redemptions generally yield capital gains, if the fund instead exits by liquidating its underlying properties, depreciation recapture rules apply.⁵ In that scenario, straight-line depreciation is taxed at up to 25%, and any accelerated depreciation is recaptured at ordinary income rates.⁵

The bottom line

By pairing cost segregation studies with a REIT structure, private real estate funds can transform the tax profile of an investment. For investors in the DLP Housing Fund, this has historically meant both tax-sheltered distributions today and lower taxes on the back end—a strategy that keeps more capital working for investors over the long haul.