Fresnel Incoherent Correlation Holography (FINCH) allows digital reconstruction of incoherently illuminated objects from intensity records acquired by a Spatial Light Modulator (SLM). The article presents wave optics model of FINCH, which allows analytical calculation of the Point Spread Function (PSF) for both the optical and digital part of imaging and takes into account Gaussian aperture for a spatial bounding of light waves. The 3D PSF is used to determine diffraction limits of the lateral and longitudinal size of a point image created in the FINCH set-up. Lateral and longitudinal resolution is investigated both theoretically and experimentally using quantitative measures introduced for two-point imaging. Dependence of the resolving power on the system parameters is studied and optimal geometry of the set-up is designed with regard to the best lateral and longitudinal resolution. Theoretical results are confirmed by experiments in which the light emitting diode (LED) is used as a spatially incoherent source to create object holograms using the SLM.