Security Deposit: Follow Oregon’s rules—return deposits within 31 days with documented deductions.5.

So, you're not "wrong" in thinking it's complicated.The tax code plays heavily into how certain transactions are categorized and there is some flexibility regarding what we can capitalize versus deduct.

The #1 way real estate investors defer taxes to later dates is with a system called depreciation and bonus depreciation.Depreciation is the act of slowly, over time, deducting the initial expense of an asset against your taxable income.Generally over a 27.5 (residential) or 39 (commercial) yr time frame.So each year you can write off a few percent of the purchase price against your income. 

To determine if the expense should be classified as a capital improvement or a deductible repair, the context of the expense is very important.An example is, if an item of expenditure is part of a general plan of modernization, renovation or rehabilitation to equipment or other business property, it typically must be capitalized even though on its own it would be currently deductible.According to IRS Code, expenses that you must capitalize are those that:Materially increase valueSubstantially prolong useful life (including replacement of deteriorating assets)Adapt the property to a new or different useHowever, you are allowed to deduct expenses and fees for routine maintenance and repairs that help keep the property in efficient operating condition.

I used to even include a clip of the newspaper articles when a major levy was passed.   

Lastly, don’t forget about the tax benefits, you can often deduct mortgage interest, repairs, and other expenses.If you need help navigating any part of the process, from financing future investments to managing your rental, feel free to reach out. 

If you collected an insurance claim you would only be able to collect your out of pocket (ie deductible).

Also, since you never gave the keys for possession, highly unlikely a judge will even allow you to deduct per diem rent from the SD.After losing a couple of court cases on scenarios similar to yours, we huddled with our attorneys, who recommended charging a Holding Fee.We have a Holding Fee Agreement we require prospects to sign to hold a property until they later sign a lease.

Or do I still complete the 1031 exchange for the full $2.5MM, with the $500K deduction only reducing the deferred tax owed?

Tax ConsiderationsSTR income is taxed higher than LTR, but deductible expenses (e.g., repairs, furnishings) can offset this.