TAXATION OF REAL ESTATE
INVESTMENTS

Taxable income
Cost recovery
Gain on sale

Interest

Passive activities

Real estate investments are taxed on the income they produce and on the increase in value, or gain, when the investment is sold. These forms of taxation are distinct from the ad valorem taxation of real estate.

Taxable Income          

Taxable income from investment real estate is the gross income received minus any expenses, deductions or exclusions that current tax law allows. Taxable income from real estate is added to the investor’s other income and taxed at the investor’s marginal tax rate. The “Investment Analysis of an Income Property” section below gives details.

Cost recovery             

Cost recovery, or depreciation, allows the owner of income property to deduct a portion of the property’s value from gross income each year over the life of the asset. The “life of the asset” and the deductible portion are defined by law. In theory, the owner recovers the full cost of the investment if it is held to the end of the asset’s economic life as defined by the Internal Revenue Service. At the time of selling the asset, the accumulated cost recovery is subtracted from the investment’s original value as part of determining the taxable capital gain.

Cost recovery is allowed only for income properties and that portion of a non-income property which is used to produce income. It applies only to improvements. Land cannot be depreciated. The part of a property which can be depreciated is called the depreciable basis.

Depreciation schedules. Residential rental properties are depreciated over a period of 27.5 years. The basic annual deduction for such property is 3.636%, with adjustments for the month of the taxable year in which the property was placed in service. Non-residential income properties placed in service after 1994 are depreciated over a period of 39 years (basic annual percentage is 2.564%). The proper method of depreciation should be determined in consultation with a qualified tax advisor.

Gain on sale                

When real estate, whether non-income or income, is sold, a taxable event occurs. If the sale proceeds exceed the original cost of the investment, subject to some adjustments, there is a capital gain that is subject to tax. If the sales proceeds are less than the original cost with adjustments, there is a capital loss.

An investor can sometimes defer the reporting of gain or loss, and, hence, taxation of gain, by participating in an exchange of like-kind assets. The legislation that deals with like-kind exchanges is contained in Section 1031 of the IRS code. These tax-deferred exchanges are sometimes called Section 1031 exchanges and Starker exchanges, named for an investor who won a case against the IRS.

To qualify under Section 1031, there must have been a legitimate exchange of the assets involved. The property being transferred must have been held for productive use in a trade or business or held as an investment and must be exchanged for property that will also be used in a trade or business or be held as an investment. Tax on gain is deferred until the investment or business property is sold and not exchanged.

Interest                        

Mortgage interest incurred by loans to buy, build, or materially improve a primary or secondary residence is deductible from gross income. The interest on a home equity loan may be deducted only if the loan is used to “buy, build or substantially improve” the home that secures the loan. Principal payments on a loan are not deductible.

For income properties that are held as investments, interest on debts incurred to finance the investment is deductible as investment interest up to the amount of net income received from the property.