18.4 Taxation of RE Investments

Big Picture: What Gets Taxed

Real estate investments are generally taxed on:

• Income: the cash flow/income stream the property produces (after allowable deductions).
• Gain on sale: the increase in value (capital gain) when the property is sold (subject to rules and adjustments).

Taxable Income (Income Properties)

Taxable income from investment real estate is generally:
gross income minus allowable expenses, deductions, and exclusions under current tax law.
This taxable income is added to the investor’s other income and taxed at the investor’s marginal tax rate.

Cost Recovery (Depreciation)

Cost recovery (depreciation) allows the owner of an income property to deduct a portion of the property’s value each year over the life of the asset as defined by the IRS.
Over time, the owner “recovers” the cost of the investment through these annual deductions.

• Cost recovery is allowed only for income properties (and the income-producing portion of a non-income property).
• Depreciation applies only to improvements—land cannot be depreciated.
• The portion that can be depreciated is the depreciable basis.

When the property is sold, accumulated depreciation affects the calculation of taxable capital gain.

Gain on Sale (Capital Gain) and 1031 Exchanges

When real estate is sold, a taxable event occurs. If sale proceeds exceed the original cost (with adjustments), there is a capital gain. If proceeds are less, there is a capital loss.

To qualify, the property transferred must be held for productive use in a trade/business or as an investment, and it must be exchanged for property to be used similarly.

Interest Deductions

Mortgage interest may be deductible, but the rules depend on the type of property and how the loan proceeds are used.
Principal payments are not deductible.

• Primary/secondary residence: interest may be deductible for loans used to buy, build, or materially improve the home (subject to limitations).
• Home equity loans: interest may be deductible only if the loan is used to “buy, build, or substantially improve” the home securing the loan.
• Income properties: interest on debt used to finance the investment may be deductible as investment interest up to net income received from the property.

Passive Activities

Passive activities are business activities in which the taxpayer does not materially participate. This often includes:

• interests in limited partnerships
• rental activities

Losses from passive activities may be used to offset income from other passive activities. With limitations, passive losses may be carried forward to future years or accumulated and deducted from capital gain at the time of sale.

Quick Check-Ins (Self-Test)