During the industrial revolution, businesses found themselves investing in increasingly larger machines and structures. Railroad companies in particular had huge expenditures in the years they acquired new locomotives. In the accounting system of the time, these companies would show a huge loss in the year the investment was made, masking what sometimes was an underlying profitable business. The asset had a limited useful life and would eventually have to be replaced, resulting in another huge expense. To smooth profit and loss statements and aid in long-term business planning, companies deducted small proportions of the costs of these assets every year over the life of the asset instead of all in one year. This accounting process caught on and, in 1913, was adopted as a tax deduction by the Internal Revenue Service.
IRS depreciation rules are not as straightforward as the concept. The IRS allows for two primary depreciation methods: GDS (general depreciation system) and ADS (alternative depreciation system). In GDS, you can use straight-line depreciation, which results in the same deduction every year over the life of the asset, or one of two types of accelerated depreciation, which allows you to depreciate more in the asset's early years of service. In ADS, you must select straight-line depreciation.
When you sell a rental property, you will owe what is called capital gains tax on the profit. This is a flat 15 percent tax, which is lower than most rates rental property owners have to pay on their ordinary income from wages. Additionally, you must identify the total amount of depreciation you claimed on the property over all years of ownership. That amount is subject to a 25 percent tax.
Section 1031 of the Internal Revenue Code allows a real estate investor to sell a rental property without having to pay tax on either the profit, called capital gains, or the depreciation when he sells the property through what is known as a deferred exchange or 1031 exchange. In this process, a third party called a qualified intermediary holds all of the proceeds from the sale until the funds move into the purchase of a replacement property. The replacement property must be identified within 45 days from the sale of the first property, and it must close escrow within six months from the sale. There are no limitations on how many times you can buy and sell through 1031 exchanges. If you continue using this process with each subsequent sale, you will never pay either the recapture or capital gains tax.