When an investor has to pay a lender more to finance the investment than the investment property generates in income, the investor suffers from

Leveraging is borrowing funds in order to make an investment that is larger than your own resource permits you to do directly. In negative leverage situations, your cost of borrowing funds to make the investment becomes greater than the income the investment returns to you. Leverage means borrowing funds to control an investment larger than your own cash allows. Negative leverage occurs when the cost of that borrowed money exceeds the income the investment produces, so each dollar financed actually reduces the investor's return.

A homeowner bought a house five years ago for $450,000. Since then, the homeowner has spent $9,000 to pave the driveway and has added a central heating/airconditioning system at a cost of $12,000. What is the homeowner's adjusted basis if the house is sold today?

The beginning basis is the cost of acquiring a property. Basis is increased by capital improvements and decreased by depreciation. The basic formula for adjusted basis is Beginning basis ($450,000) + capital improvements ($9,000 + $12,000) - depreciation ($0) = adjusted basis ($471,000). Adjusted basis begins with the owner's acquisition cost, increases by capital improvements, and decreases by depreciation taken. Routine repairs do not change basis, but improvements do. The driveway and heating system are improvements, so $450,000 plus $9,000 plus $12,000 equals $471,000.

Elmo Gilmore owns a small retail property that he inherited from his father. There are no mortgages or interest expenses connected with the property. Elmo takes an annual cost recovery expense of $5,000. The property has a monthly gross income of $1,500 and monthly operating expenses of $500. Elmo's taxable income from this property will be taxed at a rate of 30%. What is the tax liability for the year?

Annual gross operating income ($1,500 x 12 = $18,000) - annual operating expenses ($500 x 12 = $6,000) = annual net operating income ($12,000); annual net operating income ($12,000) - cost recovery expense ($5,000) = taxable income ($7,000); taxable income ($7,000) x tax rate (30%) = tax liability ($2,100). Taxable income from an investment property equals gross income minus operating expenses minus cost recovery (depreciation). Tax owed is that taxable income times the investor's marginal rate. Here: $18,000 gross minus $6,000 expenses minus $5,000 cost recovery equals $7,000 taxable, times 30% equals $2,100.

Six investors purchase a shopping center. One investor manages the tenants and another handles the marketing and leasing. Two investors manage accounting and finance, and the remaining two run the management office. This is a possible example of

A general partnership is a syndicate in which all members participate equally in managing the investment and in the profits or losses it generates. In a general partnership, every partner takes part in managing the venture and shares proportionally in profits and losses. A limited partnership instead has general partners who manage and limited partners who invest passively. The scenario shows all six owners sharing management roles.

a real estate investment trust.

The formula for calculating capital gain tax is the taxpayer's tax bracket multiplied by

The formula for gain tax is Taxable Gain on Sale x the owner's marginal tax bracket. The formula for gain on sale is: Amount Realized - Adjusted Basis = Gain on Sale. The formula for Amount Realized is: Selling Price - Selling costs = Amount Realized. Therefore, the gain tax = (Amount Realized - Adjusted Basis) x tax rate. Gain on sale equals amount realized minus adjusted basis, where amount realized is selling price minus selling costs. The capital gains tax is that gain multiplied by the owner's marginal tax bracket. Net proceeds and starting basis are not part of the gain formula.

the sum of the beginning basis plus gain.

the sum of net sale proceeds and capital gain.

the difference between net sale proceeds and capital gain.

A town is replacing a sidewalk that serves five homes. The length of the sidewalk is 200 feet. Mary's property has 38 feet of front footage. If the cost of the project to be paid by a special assessment is $30,000, what will Mary's assessment be?

Special assessments are based on the cost of the improvement and apportioned on a pro rata basis among benefiting properties according to the value that each parcel will receive from the improvement. Here, Mary's share is 38 / 200, or 19%. 19% x $30,000 = $5,700. A special assessment charges only properties that benefit from a public improvement, with costs shared pro rata by the benefit each receives. Front footage is the usual measure, so Mary pays 38 divided by 200, or 19%, of $30,000, which equals $5,700.

The classes protected against discrimination by the Fair Housing Act of 1968 are

Title VIII of the Civil Rights Act of 1968, known today as the Fair Housing Act, prohibits discrimination in housing based on race, color, religion, or national origin. Title VIII of the Civil Rights Act of 1968, the Fair Housing Act, banned discrimination in housing based on race, color, religion, and national origin. Sex, handicap, and familial status were not added until the Fair Housing Amendments Act of 1988. Age is not a protected class under federal law.

Which of the following actions is allowed under federal fair housing laws?

The Fair Housing Act would exempt the owner in this situation because it involves rental of an apartment in a 1-4 unit building where the owner is also an occupant and there is no discriminatory advertising. The Fair Housing Act exempts an owner who lives in a one-to-four unit building and rents the remaining unit, as long as no discriminatory advertising is used. That exemption does not cover larger rental holdings or any discriminatory ads. Advertisements that limit buyers or tenants by protected class remain illegal.

A broker, following the instructions of the seller, advertises the property as for sale to Christian families only.

A home seller, acting without a broker, places a "for sale-- mature, single men only" sign in front of the house.

The owner of four rental houses advertises one of the properties for rent to married couples, no children, no pets.

Which of the following laws or rulings extended discrimination to include gender, handicapped status, and family status?

The Fair Housing Amendments Act of 1988 prohibited discrimination based on sex and discrimination against handicapped persons and families with children. Executive Order 11063 concerned racial discrimination in housing where federal funding was involved; the Civil Rights Act of 1968 concerned discrimination based on race, color, religion, and national origin; Jones v Mayer concerned racial discrimination. The Fair Housing Amendments Act of 1988 expanded federal protection to sex, handicap, and familial status, forbidding discrimination against families with children. Earlier measures covered only race, color, religion, and national origin. Knowing which law added each protected class is a recurring exam point.

Which of the following would be a non-material fact that would not have to be included in the Seller's Property Condition Disclosure form?

Sellers are not required to disclose fact that do not materially impact the value or condition of the property including suicides, AIDS-related illness, and other property stigmas. Licensees, however are required to disclose known material facts. Sellers must disclose material facts that affect a property's value or condition, including defects and contamination. Psychological stigmas such as a prior death, suicide, or illness are generally not material and need not appear on a Seller's Property Condition Disclosure form. Licensees still must disclose known material facts to clients.

A previous occupant contaminated the house by manufacturing methamphetamine in the basement.

Linda owns a property used as a rental that she purchased for $300,000. She has taken $30,000 in depreciation over several years. What is her adjusted basis in the property?

The adjusted basis is calculated by subtracting accumulated depreciation from the original purchase price. $300,000 - $30,000 = $270,000. Adjusted basis equals the original purchase price minus all depreciation (cost recovery) taken over the holding period. Depreciation cannot be skipped; it reduces basis whether or not the owner claimed it. Here, $300,000 minus $30,000 of accumulated depreciation equals an adjusted basis of $270,000.

What is one primary tax benefit of owning a principal residence, rather than an investment property?

Mortgage interest on a principal residence is tax-deductible, while cost recovery (depreciation) and capital gains deferral apply to investment properties under specific conditions. Owning a principal residence lets the owner deduct mortgage interest on their income tax return. Investment properties instead offer cost recovery (depreciation) on the structure and potential capital gains deferral through a 1031 exchange. The two property types carry different tax benefits, so match the benefit to the right ownership.

It allows cost recovery deductions.

The entire property value can be depreciated.

It allows deferral of capital gains taxes on any future sale.

Which of the following is true about depreciation of investment property?

Depreciation is only allowed on the building and improvements, not the land itself, for investment property under IRS guidelines. For investment property, depreciation (cost recovery) applies only to the building structure and its improvements, spread over the useful life set by the IRS. Land itself never depreciates because it does not wear out. A purchaser must separate land value from improvement value to claim the deduction correctly.

Land and improvements can both be depreciated.

Only the land value can be depreciated.

Depreciation applies to all property, regardless of type or use.

Steven is an investor in a limited partnership real estate project. What is true about his liability in this type of partnership?

In a limited partnership, limited partners have liability only up to the amount of their investment and do not take part in property management. In a limited partnership, general partners manage the property and carry unlimited personal liability. Limited partners supply capital, take no part in day-to-day management, and risk only the amount they invested. Passive involvement is what preserves their limited liability.

He has unlimited liability for the project’s debts.

He must pay a higher tax rate than general partners.

He is responsible for management and operation of the property.

Which of the following is a primary tax advantage of owning investment property?

Investment property owners can deduct depreciation on the property’s structure, which reduces taxable income. Land value is not depreciable. The primary tax advantage of investment property is depreciation of the structure, which reduces taxable income each year. Land value cannot be depreciated, and neither loan principal nor the property's appreciation is deductible. Cost recovery rewards ownership of income-producing real estate over time.

Ability to deduct principal repayments on loans

Deducting land value depreciation

When a property owner in a limited partnership decides to sell the property, how are the gains typically taxed for the limited partners?

Gains from the sale of a property in a limited partnership are typically taxed as capital gains for the limited partners, which may have favorable tax treatment compared to ordinary income. When a limited partnership sells real property, the resulting gain generally passes through to the limited partners and is taxed as capital gain, not ordinary income. Capital gain treatment can carry a lower rate than ordinary income. A partnership itself pays no entity-level tax.

James owns a duplex and rents out one unit while living in the other. For tax purposes, how much of the property’s depreciation can he deduct?

James can deduct the depreciation for the rental portion of the duplex but cannot depreciate the portion used as his personal residence. Depreciation is allowed only on the income-producing portion of a property. In a mixed-use duplex where the owner lives in one unit, the owner may depreciate just the rental unit and its share of the structure, not the personal residence. Splitting the property correctly protects the deduction.

Only the portion that applies to his personal residence

No depreciation is allowed for mixed-use properties

The entire depreciation of the duplex

David wants to maximize his deductions on an investment property. Which of the following is deductible?

Deductible expenses for investment properties include mortgage interest, maintenance, property management fees, and depreciation on the structure, but not the mortgage principal or appreciation. Deductible operating expenses on investment property include mortgage interest, maintenance and repairs, management fees, and depreciation on the structure. Mortgage principal repayment and the property's market value or appreciation are not deductible. Only money actually spent on operating the property reduces taxable income.

The property's fair market value

David owns a small office building and incurs various expenses. Which of the following can he typically deduct from his taxable income?

David can deduct expenses such as depreciation, repairs, and property management costs for his office building, but not the principal payments or market value. An office building owner can deduct ordinary and necessary operating costs, including depreciation on the structure, repairs that keep the property usable, and property management fees. Capital items, mortgage principal, market value, and appreciation are not deductible. The test is whether the expense relates to operating the income-producing property.

The property’s full market value

Only the property’s appreciation

A real estate investment trust (REIT) must distribute a minimum percentage of its taxable income to shareholders each year to maintain its tax-exempt status. What is this percentage?

To maintain its tax-exempt status, a REIT must distribute at least 90% of its taxable income to shareholders in the form of dividends. A real estate investment trust is a corporate form that avoids entity-level tax by passing income to shareholders. To keep that tax-exempt status, a REIT must distribute at least 90% of its taxable income each year as dividends. Shareholders then pay tax on the dividends they receive.

ApexAgent Practice Questions

Real Estate Investments and Taxation

Investment and taxation questions are where the exam tests tax treatment, return on investment, and the rules that separate investment property from a personal residence. The 20 questions below cover 1031 exchanges, depreciation, capital gains, leverage, and the math of return. Each answer explains the rule and the reasoning.

20 practice questions with answers and explanations. Written and reviewed by the ApexAgent team against the national exam content outline, updated 2026-10-04.

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What this topic tests

Depreciation reduces taxable income but applies only to the building, never the land.
Adjusted basis equals acquisition cost plus improvements minus accumulated depreciation.
General partnerships share management and liability; limited partners only risk their investment.
The 1968 Fair Housing Act covers race, color, religion, national origin; 1988 added sex, handicap, family status.
Investment property deductions include mortgage interest, repairs, management fees, and structure depreciation.
A REIT must pay out at least 90% of taxable income to keep tax-exempt status.

Jump to a question

1. When an investor has to pay a lender more
2. A homeowner bought a house five years ago for
3. Elmo Gilmore owns a small retail property that he
4. Six investors purchase a shopping center. One investor manages
5. The formula for calculating capital gain tax is the
6. A town is replacing a sidewalk that serves five
7. The classes protected against discrimination by the Fair Housing
8. Which of the following actions is allowed under federal
9. Which of the following laws or rulings extended discrimination
10. Which of the following would be a non-material fact
11. Linda owns a property used as a rental that
12. What is one primary tax benefit of owning a
13. Which of the following is true about depreciation of
14. Steven is an investor in a limited partnership real
15. Which of the following is a primary tax advantage
16. When a property owner in a limited partnership decides
17. James owns a duplex and rents out one unit
18. David wants to maximize his deductions on an investment
19. David owns a small office building and incurs various
20. A real estate investment trust (REIT) must distribute a

20 real estate exam questions on this topic

Question 1 of 20
When an investor has to pay a lender more to finance the investment than the investment property generates in income, the investor suffers from
- negative amortization.
- negative leverage.Correct answer
- a reverse mortgage.
- a debt investment.
Correct answer: B. negative leverage.
Why: Leveraging is borrowing funds in order to make an investment that is larger than your own resource permits you to do directly. In negative leverage situations, your cost of borrowing funds to make the investment becomes greater than the income the investment returns to you.
The rule: Leverage means borrowing funds to control an investment larger than your own cash allows. Negative leverage occurs when the cost of that borrowed money exceeds the income the investment produces, so each dollar financed actually reduces the investor's return.
Why the other options are wrong
- Negative amortization describes a loan balance growing because payments do not cover interest, not borrowing costs exceeding income.
- A reverse mortgage is a loan for older homeowners tapping equity, unrelated to leverage returns.
- A debt investment means lending money for a fixed return, not borrowing more than the property earns.
Question 2 of 20
A homeowner bought a house five years ago for $450,000. Since then, the homeowner has spent $9,000 to pave the driveway and has added a central heating/airconditioning system at a cost of $12,000. What is the homeowner's adjusted basis if the house is sold today?
- $468,000.00
- $471,000.00Correct answer
- $429,000.00
- $435,000.00
Correct answer: B. $471,000.00
Why: The beginning basis is the cost of acquiring a property. Basis is increased by capital improvements and decreased by depreciation. The basic formula for adjusted basis is Beginning basis ($450,000) + capital improvements ($9,000 + $12,000) - depreciation ($0) = adjusted basis ($471,000).
The rule: Adjusted basis begins with the owner's acquisition cost, increases by capital improvements, and decreases by depreciation taken. Routine repairs do not change basis, but improvements do. The driveway and heating system are improvements, so $450,000 plus $9,000 plus $12,000 equals $471,000.
Why the other options are wrong
- Understating the total means an improvement was mis-added; basis increases by every capital expenditure made.
- This subtracts the improvements from cost; basis is increased by capital improvements, not reduced by them.
- Deducting a guessed amount instead of adding improvements violates the rule that only real depreciation lowers adjusted basis.
Question 3 of 20
Elmo Gilmore owns a small retail property that he inherited from his father. There are no mortgages or interest expenses connected with the property. Elmo takes an annual cost recovery expense of $5,000. The property has a monthly gross income of $1,500 and monthly operating expenses of $500. Elmo's taxable income from this property will be taxed at a rate of 30%. What is the tax liability for the year?
- $2,100.00Correct answer
- $3,600.00
- $3,900.00
- $7,000.00
Correct answer: A. $2,100.00
Why: Annual gross operating income ($1,500 x 12 = $18,000) - annual operating expenses ($500 x 12 = $6,000) = annual net operating income ($12,000); annual net operating income ($12,000) - cost recovery expense ($5,000) = taxable income ($7,000); taxable income ($7,000) x tax rate (30%) = tax liability ($2,100).
The rule: Taxable income from an investment property equals gross income minus operating expenses minus cost recovery (depreciation). Tax owed is that taxable income times the investor's marginal rate. Here: $18,000 gross minus $6,000 expenses minus $5,000 cost recovery equals $7,000 taxable, times 30% equals $2,100.
Why the other options are wrong
- This applies the tax rate to net operating income, ignoring the annual cost recovery deduction that lowers taxable income.
- Subtracting cost recovery from gross income but skipping operating expenses overstates taxable income here.
- This is the taxable income figure before the 30% rate is applied, so no tax has actually been computed.
Question 4 of 20
Six investors purchase a shopping center. One investor manages the tenants and another handles the marketing and leasing. Two investors manage accounting and finance, and the remaining two run the management office. This is a possible example of
- a general partnership.Correct answer
- a limited partnership.
- a real estate investment trust.
- an investment conduit.
Correct answer: A. a general partnership.
Why: A general partnership is a syndicate in which all members participate equally in managing the investment and in the profits or losses it generates.
The rule: In a general partnership, every partner takes part in managing the venture and shares proportionally in profits and losses. A limited partnership instead has general partners who manage and limited partners who invest passively. The scenario shows all six owners sharing management roles.
Why the other options are wrong
- A limited partnership separates passive investors from active general partners, but here all six investors share management duties.
- A real estate investment trust is a corporate vehicle with many shareholders, not six owners running a shopping center directly.
- An investment conduit describes a tax pass-through structure, not the active, shared management of a general partnership.
Question 5 of 20
The formula for calculating capital gain tax is the taxpayer's tax bracket multiplied by
- the sum of the beginning basis plus gain.
- the difference between amount realized and adjusted basis.Correct answer
- the sum of net sale proceeds and capital gain.
- the difference between net sale proceeds and capital gain.
Correct answer: B. the difference between amount realized and adjusted basis.
Why: The formula for gain tax is Taxable Gain on Sale x the owner's marginal tax bracket. The formula for gain on sale is: Amount Realized - Adjusted Basis = Gain on Sale. The formula for Amount Realized is: Selling Price - Selling costs = Amount Realized. Therefore, the gain tax = (Amount Realized - Adjusted Basis) x tax rate.
The rule: Gain on sale equals amount realized minus adjusted basis, where amount realized is selling price minus selling costs. The capital gains tax is that gain multiplied by the owner's marginal tax bracket. Net proceeds and starting basis are not part of the gain formula.
Why the other options are wrong
- Adding beginning basis to the gain confuses basis with the sale computation; gain is what remains after basis is subtracted.
- Adding net proceeds and gain double counts the sale; the gain tax uses amount realized minus adjusted basis.
- Subtracting capital gain from net proceeds reverses the formula; adjusted basis, not gain, is subtracted from amount realized.
Question 6 of 20
A town is replacing a sidewalk that serves five homes. The length of the sidewalk is 200 feet. Mary's property has 38 feet of front footage. If the cost of the project to be paid by a special assessment is $30,000, what will Mary's assessment be?
- $6,000.00
- $5,700.00Correct answer
- $789.00
- $1,579.00
Correct answer: B. $5,700.00
Why: Special assessments are based on the cost of the improvement and apportioned on a pro rata basis among benefiting properties according to the value that each parcel will receive from the improvement. Here, Mary's share is 38 / 200, or 19%. 19% x $30,000 = $5,700.
The rule: A special assessment charges only properties that benefit from a public improvement, with costs shared pro rata by the benefit each receives. Front footage is the usual measure, so Mary pays 38 divided by 200, or 19%, of $30,000, which equals $5,700.
Why the other options are wrong
- Dividing the total equally among five homes ignores that special assessments are allocated by each parcel's benefit, here front footage.
- Dividing total cost by Mary's footage inverts the ratio; her share is her frontage divided by total frontage.
- Doubling or inverting the ratio produces this figure; Mary pays only 38/200 of the $30,000 project cost.
Question 7 of 20
The classes protected against discrimination by the Fair Housing Act of 1968 are
- race only.
- religion and gender only.
- race, color, religion, and national origin.Correct answer
- age and gender only.
Correct answer: C. race, color, religion, and national origin.
Why: Title VIII of the Civil Rights Act of 1968, known today as the Fair Housing Act, prohibits discrimination in housing based on race, color, religion, or national origin.
The rule: Title VIII of the Civil Rights Act of 1968, the Fair Housing Act, banned discrimination in housing based on race, color, religion, and national origin. Sex, handicap, and familial status were not added until the Fair Housing Amendments Act of 1988. Age is not a protected class under federal law.
Why the other options are wrong
- Race alone understates the original 1968 list, which also covers color, religion, and national origin.
- Gender was added later by the 1988 amendments, and this option omits color and national origin from 1968.
- Age is not a protected class under federal fair housing, and gender came from the 1988 amendments, not 1968.
Question 8 of 20
Which of the following actions is allowed under federal fair housing laws?
- A broker, following the instructions of the seller, advertises the property as for sale to Christian families only.
- A home seller, acting without a broker, places a "for sale-- mature, single men only" sign in front of the house.
- The owner of four rental houses advertises one of the properties for rent to married couples, no children, no pets.
- The owner of a duplex who resides in one of the units refuses to rent the other unit to a non-Christian.Correct answer
Correct answer: D. The owner of a duplex who resides in one of the units refuses to rent the other unit to a non-Christian.
Why: The Fair Housing Act would exempt the owner in this situation because it involves rental of an apartment in a 1-4 unit building where the owner is also an occupant and there is no discriminatory advertising.
The rule: The Fair Housing Act exempts an owner who lives in a one-to-four unit building and rents the remaining unit, as long as no discriminatory advertising is used. That exemption does not cover larger rental holdings or any discriminatory ads. Advertisements that limit buyers or tenants by protected class remain illegal.
Why the other options are wrong
- Following a seller's discriminatory advertising instruction still violates fair housing; brokers may not advertise on prohibited grounds.
- A sign limiting buyers by gender and marital status is discriminatory advertising, which is illegal regardless of who posts it.
- The owner-occupant exemption applies only to one-to-four unit buildings, and this owner occupies none of these rentals.
Question 9 of 20
Which of the following laws or rulings extended discrimination to include gender, handicapped status, and family status?
- Executive Order 11063
- the Civil Rights Act of 1968.
- the Fair Housing Amendments Act of 1988.Correct answer
- Jones v Mayer.
Correct answer: C. the Fair Housing Amendments Act of 1988.
Why: The Fair Housing Amendments Act of 1988 prohibited discrimination based on sex and discrimination against handicapped persons and families with children. Executive Order 11063 concerned racial discrimination in housing where federal funding was involved; the Civil Rights Act of 1968 concerned discrimination based on race, color, religion, and national origin; Jones v Mayer concerned racial discrimination.
The rule: The Fair Housing Amendments Act of 1988 expanded federal protection to sex, handicap, and familial status, forbidding discrimination against families with children. Earlier measures covered only race, color, religion, and national origin. Knowing which law added each protected class is a recurring exam point.
Why the other options are wrong
- Executive Order 11063 addressed racial discrimination in federally funded housing, not gender or family status.
- The 1968 Civil Rights Act protected race, color, religion, and national origin; sex and handicap came later.
- Jones v Mayer was a racial discrimination case and did not add sex, handicap, or familial status protections.
Question 10 of 20
Which of the following would be a non-material fact that would not have to be included in the Seller's Property Condition Disclosure form?
- A house has a leaking roof.
- A basement floods.
- A previous occupant died in the house.Correct answer
- A previous occupant contaminated the house by manufacturing methamphetamine in the basement.
Correct answer: C. A previous occupant died in the house.
Why: Sellers are not required to disclose fact that do not materially impact the value or condition of the property including suicides, AIDS-related illness, and other property stigmas. Licensees, however are required to disclose known material facts.
The rule: Sellers must disclose material facts that affect a property's value or condition, including defects and contamination. Psychological stigmas such as a prior death, suicide, or illness are generally not material and need not appear on a Seller's Property Condition Disclosure form. Licensees still must disclose known material facts to clients.
Why the other options are wrong
- A leaking roof materially affects value and condition, so sellers must disclose this known defect.
- A flooded basement is a material structural and value issue that belongs on the seller's disclosure.
- Methamphetamine contamination is a material health and value hazard that must be disclosed, unlike a death.
Question 11 of 20
Linda owns a property used as a rental that she purchased for $300,000. She has taken $30,000 in depreciation over several years. What is her adjusted basis in the property?
- $300,000
- $240,000
- $270,000Correct answer
- $330,000
Correct answer: C. $270,000
Why: The adjusted basis is calculated by subtracting accumulated depreciation from the original purchase price. $300,000 - $30,000 = $270,000.
The rule: Adjusted basis equals the original purchase price minus all depreciation (cost recovery) taken over the holding period. Depreciation cannot be skipped; it reduces basis whether or not the owner claimed it. Here, $300,000 minus $30,000 of accumulated depreciation equals an adjusted basis of $270,000.
Why the other options are wrong
- Using the original purchase price ignores the accumulated depreciation, which must be subtracted from basis.
- This subtracts more than the stated depreciation; only $30,000 of cost recovery reduces the $300,000 basis.
- Adding depreciation to basis instead of subtracting it reverses the rule that cost recovery lowers adjusted basis.
Question 12 of 20
What is one primary tax benefit of owning a principal residence, rather than an investment property?
- It allows cost recovery deductions.
- The entire property value can be depreciated.
- Mortgage interest is deductible on the owner’s income tax.Correct answer
- It allows deferral of capital gains taxes on any future sale.
Correct answer: C. Mortgage interest is deductible on the owner’s income tax.
Why: Mortgage interest on a principal residence is tax-deductible, while cost recovery (depreciation) and capital gains deferral apply to investment properties under specific conditions.
The rule: Owning a principal residence lets the owner deduct mortgage interest on their income tax return. Investment properties instead offer cost recovery (depreciation) on the structure and potential capital gains deferral through a 1031 exchange. The two property types carry different tax benefits, so match the benefit to the right ownership.
Why the other options are wrong
- Principal residences do not qualify for cost recovery; depreciation deductions belong to income-producing investment property.
- You cannot depreciate a residence's value; depreciation applies only to investment property's structure and improvements.
- Gains deferral comes from a 1031 exchange on investment property, not automatic treatment of a principal residence.
Question 13 of 20
Which of the following is true about depreciation of investment property?
- Land and improvements can both be depreciated.
- Only the land value can be depreciated.
- Depreciation applies to all property, regardless of type or use.
- Only the building structure and improvements can be depreciated.Correct answer
Correct answer: D. Only the building structure and improvements can be depreciated.
Why: Depreciation is only allowed on the building and improvements, not the land itself, for investment property under IRS guidelines.
The rule: For investment property, depreciation (cost recovery) applies only to the building structure and its improvements, spread over the useful life set by the IRS. Land itself never depreciates because it does not wear out. A purchaser must separate land value from improvement value to claim the deduction correctly.
Why the other options are wrong
- Land is never depreciable, so pairing it with improvements misstates the rule that only the structure can be written down.
- Depreciating only land reverses the rule; land cannot be depreciated while the building can.
- Only income-producing property qualifies for depreciation, so the blanket statement about all property is far too broad.
Question 14 of 20
Steven is an investor in a limited partnership real estate project. What is true about his liability in this type of partnership?
- He has unlimited liability for the project’s debts.
- He must pay a higher tax rate than general partners.
- He is responsible for management and operation of the property.
- He has limited liability up to the amount of his investment.Correct answer
Correct answer: D. He has limited liability up to the amount of his investment.
Why: In a limited partnership, limited partners have liability only up to the amount of their investment and do not take part in property management.
The rule: In a limited partnership, general partners manage the property and carry unlimited personal liability. Limited partners supply capital, take no part in day-to-day management, and risk only the amount they invested. Passive involvement is what preserves their limited liability.
Why the other options are wrong
- Unlimited liability describes a general partner; a limited partner risks only the capital invested in the project.
- Limited partners are not taxed at a higher rate; partnership income passes through at each partner's own rate.
- Management is the job of general partners; limited partners who take an active role risk losing their liability protection.
Question 15 of 20
Which of the following is a primary tax advantage of owning investment property?
- Depreciation deductions on the property’s structureCorrect answer
- Ability to deduct principal repayments on loans
- Deducting land value depreciation
- Exclusion from property taxes
Correct answer: A. Depreciation deductions on the property’s structure
Why: Investment property owners can deduct depreciation on the property’s structure, which reduces taxable income. Land value is not depreciable.
The rule: The primary tax advantage of investment property is depreciation of the structure, which reduces taxable income each year. Land value cannot be depreciated, and neither loan principal nor the property's appreciation is deductible. Cost recovery rewards ownership of income-producing real estate over time.
Why the other options are wrong
- Mortgage principal builds equity and is not deductible; only the interest portion qualifies as an expense.
- Fair market value is not an expense paid out, so it cannot be deducted from taxable income.
- Appreciation is unrealized gain, not a cash expense, and is taxed on sale rather than deducted yearly.
Question 16 of 20
When a property owner in a limited partnership decides to sell the property, how are the gains typically taxed for the limited partners?
- As ordinary income
- At the corporate tax rate
- As capital gainsCorrect answer
- As tax-free income
Correct answer: C. As capital gains
Why: Gains from the sale of a property in a limited partnership are typically taxed as capital gains for the limited partners, which may have favorable tax treatment compared to ordinary income.
The rule: When a limited partnership sells real property, the resulting gain generally passes through to the limited partners and is taxed as capital gain, not ordinary income. Capital gain treatment can carry a lower rate than ordinary income. A partnership itself pays no entity-level tax.
Why the other options are wrong
- Sale gains are capital, not ordinary income; the difference matters because capital gains often get favorable treatment.
- A partnership is not taxed at corporate rates; gains pass through to partners and are taxed at their own level.
- Sale proceeds are not tax-free; the gain is recognized and taxed, typically as a capital gain, not excluded.
Question 17 of 20
James owns a duplex and rents out one unit while living in the other. For tax purposes, how much of the property’s depreciation can he deduct?
- Only the portion that applies to his personal residence
- No depreciation is allowed for mixed-use properties
- The entire depreciation of the duplex
- Only the portion that applies to the rental unitCorrect answer
Correct answer: D. Only the portion that applies to the rental unit
Why: James can deduct the depreciation for the rental portion of the duplex but cannot depreciate the portion used as his personal residence.
The rule: Depreciation is allowed only on the income-producing portion of a property. In a mixed-use duplex where the owner lives in one unit, the owner may depreciate just the rental unit and its share of the structure, not the personal residence. Splitting the property correctly protects the deduction.
Why the other options are wrong
- Depreciating the personal-residence portion reverses the rule; only the income-producing unit qualifies for cost recovery.
- Mixed-use property does allow depreciation on the rental unit, so a blanket denial is wrong.
- Depreciating the whole duplex would write off the owner's own living space, which is not income-producing.
Question 18 of 20
David wants to maximize his deductions on an investment property. Which of the following is deductible?
- Mortgage principal payments
- Mortgage interest and maintenance costsCorrect answer
- The property's fair market value
- The property’s appreciation
Correct answer: B. Mortgage interest and maintenance costs
Why: Deductible expenses for investment properties include mortgage interest, maintenance, property management fees, and depreciation on the structure, but not the mortgage principal or appreciation.
The rule: Deductible operating expenses on investment property include mortgage interest, maintenance and repairs, management fees, and depreciation on the structure. Mortgage principal repayment and the property's market value or appreciation are not deductible. Only money actually spent on operating the property reduces taxable income.
Why the other options are wrong
- Mortgage principal builds equity and is not deductible; only the interest portion qualifies as an expense.
- Fair market value is not an expense paid out, so it cannot be deducted from taxable income.
- Appreciation is unrealized gain, not a cash expense, and is taxed on sale rather than deducted yearly.
Question 19 of 20
David owns a small office building and incurs various expenses. Which of the following can he typically deduct from his taxable income?
- The property’s full market value
- Mortgage principal payments
- Depreciation, repairs, and property management costsCorrect answer
- Only the property’s appreciation
Correct answer: C. Depreciation, repairs, and property management costs
Why: David can deduct expenses such as depreciation, repairs, and property management costs for his office building, but not the principal payments or market value.
The rule: An office building owner can deduct ordinary and necessary operating costs, including depreciation on the structure, repairs that keep the property usable, and property management fees. Capital items, mortgage principal, market value, and appreciation are not deductible. The test is whether the expense relates to operating the income-producing property.
Why the other options are wrong
- Full market value is not a paid expense, so it cannot be written off against the building's rental income.
- Mortgage principal is equity, not an operating cost, so it is not deductible from taxable income.
- Appreciation is unrealized and untaxed until sale, so it is not a current deduction.
Question 20 of 20
A real estate investment trust (REIT) must distribute a minimum percentage of its taxable income to shareholders each year to maintain its tax-exempt status. What is this percentage?
- 50%
- 75%
- 100%
- 90%Correct answer
Correct answer: D. 90%
Why: To maintain its tax-exempt status, a REIT must distribute at least 90% of its taxable income to shareholders in the form of dividends.
The rule: A real estate investment trust is a corporate form that avoids entity-level tax by passing income to shareholders. To keep that tax-exempt status, a REIT must distribute at least 90% of its taxable income each year as dividends. Shareholders then pay tax on the dividends they receive.
Why the other options are wrong
- Fifty percent understates the requirement; a REIT must distribute at least 90% of taxable income to keep its tax-exempt status.
- Seventy-five percent is too low; the correct minimum distribution to shareholders is 90% of taxable income.
- A REIT need not distribute everything; it must pay out at least 90%, and may retain the remaining share.

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Investments, Taxation and Professional Practices: frequently asked

How is the adjusted basis of an investment property calculated?

Start with the property's acquisition cost, add the cost of any capital improvements, and subtract all depreciation taken over the ownership period. Routine repairs do not change basis. For example, a $300,000 purchase with $30,000 of accumulated depreciation has an adjusted basis of $270,000.

What expenses can I deduct on a rental property?

Deductible operating expenses include mortgage interest, repairs and maintenance, property management fees, and depreciation on the building structure. Mortgage principal, the property's market value, and unrealized appreciation are not deductible. Only the income-producing structure, never the land, can be depreciated over its useful life.

Which protected classes does federal fair housing law cover?

The Fair Housing Act of 1968 prohibits discrimination based on race, color, religion, and national origin. The 1988 amendments added sex, handicap, and familial status, protecting families with children. Age is not a protected class under federal fair housing law, though some states add further protections.

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