There's no doubt about it – one of the greatest benefits of real estate investment are the tax benefits the investor receives! It's entirely legal to shelter income and defer capital gains. It's entirely legal to minimize taxation and maximize the money the investor keeps on an after-tax basis.
The concept of depreciation (also known as cost recovery) operates on the assumption that physical assets lose an equal amount of value each year due to wear and tear. Another term for this is “non-cash expense.” In other words, it doesn't really take any cash out of the investor's pocket. However, it's treated like an expense or deduction when adding up your income.
And the investor gets a great result from this concept – it decreases taxable income and, as a result, lets the investor shelter positive cash flow from taxation. In other words, depreciation (cost recovery) lowers income taxes for the current year and defers them to a later date.
Keep in mind that cost recovery or depreciation does not eliminate income taxes. In technical terms, an annual depreciation deduction is figured on a reduction in basis of the property. This is calculated as the investor’s original cost in the property plus capital improvements. This is then recaptured (added to the investor’s taxable profit) in full and taxed upon disposition or sale.