California Real Estate Practice Exam

An investor has purchased an apartment building. She reports income on a cash basis and will be allowed deductions for all but which of the following?

1. cost or redecorating

2. depreciation, even though the building is going up in value daily

3. interest payments on 2nd loan

4. loss of rent due to vacancies

The correct answer is: cost or redecorating

The correct response pertains to the nature of deductible expenses within the context of cash basis accounting. In real estate, an investor can deduct certain expenses related to their property to lessen taxable income. However, some deductions are subject to limitations or specific treatment based on accounting practices. In the case of choosing not to deduct the cost of redecorating, it is important to note that such expenses are typically considered capital improvements rather than ordinary deductions. Capital improvements enhance the value of the property and are not immediately deductible as necessary and ordinary expenses. Instead, they are generally added to the basis of the property and can be depreciated over time. On the other hand, depreciation is a significant deduction available even if the building’s value appreciates, as it allows owners to recover the cost of the property over its useful life. Interest payments on loans used for acquiring or improving income-producing properties are fully deductible as well, regardless of the property’s other financial conditions. Lastly, losses incurred due to vacancies should technically fall under operational losses, which are recognized business expenses that can affect the property's net income calculation. Thus, the reason the cost of redecorating is not deductible is rooted in how real estate accounting treats capital improvements versus regular maintenance or operational costs.