18.4 Taxation of RE Investments

18.4 Taxation of Real Estate Investments

Real estate investments can create taxes in two main ways: (1) taxes on the income the property produces and (2) taxes on the gain when the property is sold. In this topic, you’ll learn the key tax concepts that show up in investment analysis: taxable income, depreciation (cost recovery), capital gain, interest deductions, and passive activity rules.

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).

Note: These are separate from ad valorem property taxes (annual property taxes based on assessed value).

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.

Key idea: Cash flow and taxable income are not always the same (because some deductions are “non-cash,” like depreciation).

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.

Depreciation schedules (as presented in the text):
Residential rental property: 27.5 years (basic annual deduction: 3.636%, adjusted by month placed in service).
Non-residential income property (placed in service after 1994): 39 years (basic annual percentage: 2.564%).

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.

1031 (Starker) exchange: In some cases, an investor can defer taxation of gain by exchanging like-kind investment/business property under IRS Section 1031. Tax is deferred until the property is sold (not exchanged).

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.

Reminder: Tax rules change—use current IRS guidance for real-world decisions.

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.

Topic 18.4 Check-In

Taxes on Investments

Choose the best answer for each question, then select Check Answers.

Cost recovery (depreciation) is generally allowed for:

Depreciation applies to improvements (not land) and is generally allowed for income properties.

Which statement is TRUE about mortgage interest?

Interest may be deductible under certain rules; principal payments are not deductible.

🔒 Mark Complete unlocks when every answer is correct.