Investment property: classes of income, gain and loss, depreciation, and recapture

Classify the income first

These federal tax concepts apply to real estate investors in New York and elsewhere. Refer individual tax decisions to a qualified tax professional.

Active income includes personal-service compensation. Portfolio income includes investment interest and dividends outside an ordinary trade or business. Passive income comes from passive activities. Under § 469, businesses without material participation and rental activities generally fall in the passive category, subject to exceptions. Making rental management decisions does not turn rent into wages.

Depreciation, basis, and gain

Rental receipts differ from net taxable rental income. Deductible expenses and depreciation can reduce taxable income. Depreciation allocates the depreciable cost of income-producing improvements over time; land is not depreciable. This noncash deduction is distinct from changes in market value.

Assume no adjustments beyond those listed:

• Original basis $300,000 + capital improvements $20,000 = $320,000.
• $320,000 − depreciation $40,000 = adjusted basis $280,000.
• Sale price $350,000 − selling expenses $20,000 = amount realized $330,000.
• Amount realized $330,000 − adjusted basis $280,000 = realized gain $50,000.

Mortgage payoff affects sale cash, rather than replacing basis in this calculation. A negative difference would be a realized loss; whether a loss is currently deductible is a separate question.

Depreciation and sale-gain character

Do not equate all depreciation-related gain with ordinary income recapture. Under § 1250(b), for property held more than one year, additional depreciation is the excess of depreciation adjustments over the straight-line amount. Equal amounts yield zero additional depreciation. That does not mean all sale gain is tax-free.

Loss limitations

Section 469 generally limits passive losses against nonpassive income and carries disallowed losses forward. Income from other passive activities can absorb passive losses. The rental real estate active-participation allowance has eligibility and income limits. A fully taxable disposition of the entire interest to an unrelated person can release remaining losses under the statutory ordering rules. Distinguish income classification, gain calculation, and loss deductibility.