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Real Estate Taxation Guide: Understanding Income, Depreciation, and Tax Liability

Learn about NOI, DEP, INT, AFC, TI, TR, and TAX in real estate taxation. Discover how to calculate depreciation, manage passive activity losses, and maximize tax deductions effectively. Master the IRS income categories to optimize your real estate investments.

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Real Estate Taxation Guide: Understanding Income, Depreciation, and Tax Liability

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  1. Income Taxes and Real Estate

  2. Item Symbol Net Operating Income (NOI) - Depreciation (DEP) - Interest Expense (INT) - Amortized Financing Costs (AFC) = Taxable Income (TI) x Tax Rate (TR) = Tax Liability (TAX)

  3. Things to Remember • Repairs are an expense, improvements have to be depreciated • Maintenance is an expense, replacements must be capitalized. • Interest expense is only deductible in the year it was incurred. Prepaid interest must be amortized.

  4. Residential property can be depreciated straight-line over 27.5 years • Commercial property is depreciated over 39 years • Don’t forget the mid-month convention – property is assumed to be purchased in the middle of the month of acquisition regardless of when it was actually obtained.

  5. Depreciation • The original cost basis includes all costs associated with acquiring the property and transferring the title • Land value cannot be depreciated • The depreciable basis is the total value that can be depreciated over the recovery period • Depreciable Basis= Cost Basis- Land Amount

  6. Annual Depreciation= Depreciable Basis/ Recovery Period • mid-month convention

  7. IRS Income Categories • Active Income (e.g., salaries, wages, bonuses, and commissions.) • Portfolio Income (e.g., interest, dividends, and capital gains.) • Passive Income (e.g., rents from real estate, and royalties from oil and gas rights.)

  8. Passive Activity Loss Restrictions • Passive losses cannot be used to reduce active or portfolio income • Passive losses may be used to reduce other passive income • Passive losses not used may be used in future years or at the same time of sale • Active participants may deduct up to $25,000 in passive losses against other non-passive income, subject to limitations

  9. Rental activity is deemed passive by the IRS. • However, the IRS does differentiate between those that materially participate and those that don’t. • Material participation is more than 500 hours per year or more than 100 hours (and not less than any other participant.) • Losses not used are carried forward.

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