You're skipping over the (extremely important) part where you take out a mortgage on property.
So you buy the $500k property with $125k in cash and a $375k mortgage (25-30% down is typical for investment mortgages). Depreciation *plus mortgage interest expense* leads you to (for tax purposes) more or less break even on this investment after 10 years and so you pay no tax.
After those 10 years are up, you've now paid off around $68k of the principal, plus the asset has gained $250k in value. So from your initial $125k of capital invested, you now have ~$400k in capital that you can leverage into a $1.6M property in a 1031 exchange. That bigger loan comes with a much larger mortgage interest expense, so you continue to earn no taxable income while growing a larger and larger asset and taking a (relatively modest) cash-on-cash return.
This is very common. We have it in Norway too. It started in 1882. At that time, it was mainly farmers who had mortgages, so the idea was to encourage productivity, making it less costly for them to buy new land for cultivation (You might wonder, wouldn't this just drive up land prices? I wonder, too.)
But once you have them, they're hard to get rid of. When they were in charge for 40+ years, Labour defended them because they wanted to push for homeownership so working people didn't have to live at the mercy of landlords. In the 80s I believe they considered changing it, but then the Conservatives (who of course benefit disproportionately from the deduction) were in a position to block it. These days there is an interest deduction on ALL loans, not just mortgages. Why and how that happened I have no idea.
The deduction of business mortgage interest payments is still always less than the money you lose by having to pay interest. Paying cash will always make you more money than a mortgage unless you have something else to do with the cash.
That doesn't change my point that the only way you can pay no tax is to have less than a 3.7% ROI before mortgage principal payments.
Again, that's a bad investment. If they put the money in the stock market or a better real estate market and got a 7% return, that would be 60% higher, even after taxes.
Sure, you build equity in the properties, but you'll have to pay all those taxes you've been putting off if you ever try to use that equity. I guess the kids could sell it before they depreciate it, but I can't imagine who would intentionally waste the potential of their money so they don't have to pay the (low) capital gains tax. Again, you'd make more money paying taxes on any almost investment making over 4.3%.
So you buy the $500k property with $125k in cash and a $375k mortgage (25-30% down is typical for investment mortgages). Depreciation *plus mortgage interest expense* leads you to (for tax purposes) more or less break even on this investment after 10 years and so you pay no tax.
After those 10 years are up, you've now paid off around $68k of the principal, plus the asset has gained $250k in value. So from your initial $125k of capital invested, you now have ~$400k in capital that you can leverage into a $1.6M property in a 1031 exchange. That bigger loan comes with a much larger mortgage interest expense, so you continue to earn no taxable income while growing a larger and larger asset and taking a (relatively modest) cash-on-cash return.