Taxation is a complex topic that has a significant impact on real estate investments.  Real estate investors may pay a variety of taxes on the properties they own.  These taxes may include:

Federal income tax on the taxable income the property produces.

State income tax, which varies by state, on the taxable income the property produces.

City or county property taxes based on the assessed value of the property and a designated rate, which can vary widely. Note: This tax is considered an operating expense for the property)

Special assessments, typically to cover improvements, such as utilities or school bonds.

As a result, the tax impact can be significant because a potentially substantial portion of investment income could be reduced by the tax payments.  However, since investors are taxed according to their overall income, the impact of taxation varies among investors for the same investment.

It is important to be familiar with the various taxes that can be levied on a real estate investment.

Taxation is a world unto itself.  It is defined by legislative bodies and is made up of tax code and law.  It does not necessarily reflect real-world logic or economics.  The focus of the tax world can be summed up in three questions:

How many of the dollars going in and out of an investment will be subject to tax?

2. How much tax will be owed?

3. When will the tax be paid.

Two important characteristics to consider for tax purposes involve the transfer of money and the timing of cash flows.

First, money need not transfer between two people to have a tax impact.  This is the case for depreciation, or cost recovery.  When an asset wears out, the investor does not actually receive money back for the wear and tear on the asset.  However, the investor can write-off the wear and tear through a cost-recovery deduction, thereby lowering the actual amount of money on which the investor is taxed.

Second, the timing in which money is received or paid may have a tax consequence that occurs long after the transaction is reported.  For example, for commercial and investment properties, loan points paid at time period zero are not deducted in full in the year they are paid.  Instead, they are prorated and deducted for tax purposes over the term of the loan and any unamortized points are expensed at the time of sale.