Depreciation, called cost recovery in US tax parlance and Capital Cost Allowance in Canada, is the mechanism by which owners of income-producing real estate deduct the cost of a building's physical wear and obsolescence against taxable income over time. The deduction is non-cash: no cheque is written, yet taxable income falls each year by the depreciation amount, sheltering cash distributions from current tax.
This makes real estate one of the few asset classes where an investment can generate positive cash flow and simultaneously produce a tax loss on paper. The paradox that a building depreciates on a tax schedule while often appreciating in market value is central to why real estate has historically been attractive to taxable investors.
Under the US Modified Accelerated Cost Recovery System, established by IRS Rev. Proc. 87-56 and its successors, nonresidential commercial real property is depreciated over 39 years using the straight-line method, and residential rental property over 27.5 years.
Personal property components such as flooring, specialized HVAC, electrical systems serving specific tenants, and land improvements like parking lots qualify for shorter cost recovery periods of 5, 7, or 15 years and may be eligible for bonus depreciation under IRC §168(k). A cost segregation study identifies and reclassifies structural components into these shorter-lived categories, accelerating deductions into the early years of ownership when the time value of tax savings is highest.
For a $10 million acquisition with a $2 million land value, a cost segregation study may reclassify $1-2 million of assets into 5-15 year property, producing significant front-loaded deductions.
In Canada, depreciation is governed by the Capital Cost Allowance system under ITA Schedule II and the Income Tax Regulations. Most commercial real property (office, retail, industrial, and hotel buildings) falls into CCA Class 1, which applies a 4% declining-balance rate to the undepreciated capital cost of the building each year.
The declining-balance method produces larger deductions in early years that taper over time. Purpose-built rental housing with four or more private residential units, if designated as Class 1(d) under the Accelerated Investment Incentive rules, qualifies for a 6% declining-balance rate.
Unlike the US system's 27.5/39-year straight-line structure, Canada's declining-balance approach never fully depreciates an asset to zero; there is always a remaining UCC balance. On disposition, if the proceeds exceed the remaining undepreciated capital cost, the excess is recaptured as fully taxable income under ITA s.13.
Depreciation recapture at sale is the unavoidable consequence of having taken the deductions during the hold. In the US, unrecaptured Section 1250 depreciation (the portion of a gain attributable to straight-line depreciation previously taken on real property) is taxed at a maximum federal rate of 25% under IRC §1(h)(1)(D), compared to the 20% maximum long-term capital gains rate applicable to the remaining gain.
This spread can cost investors 5 percentage points of federal tax on a large cumulative depreciation balance. In Canada, the full amount of recaptured CCA is included in income at the taxpayer's marginal rate; there is no preferential recapture rate.
Because cost segregation and accelerated CCA strategies front-load deductions, they also front-load the eventual recapture exposure, and that tax drag must be modelled against the time value benefit of the early deductions before a cost segregation strategy is confirmed as net-positive.