So You Want to Be a Landlord

Owning a rental property qualifies you for some favorable tax breaks. Here's an overview.

THESE DAYS, IT SEEMS THAT everyone is chattering about buying real estate as an investment. Oftentimes the idea is to flip the property quickly — presumably making a huge chunk of change in a short amount of time. The truly bold, however, have a different plan: They intend to purchase a rental property.

Becoming a landlord brings some significant tax advantages. In fact, favorable IRS rules are one big reason why so many fortunes have been made in real estate. (The other big reason is that leveraging real estate investments with mortgages multiplies the upside potential, but that's a subject for another day.)

Downsides? Tenants, of course. And risk: If real estate and rental prices take a slide, your investment could lose money.

I can't help you figure out whether you've got the patience and fortitude to be a landlord, or whether real estate prices in your area are reaching a frothy level. But I can explain to you the generous tax breaks offered to those who rent out their properties. Here's what you need to know:

What You Can Write Off
I'm sure you already know you can deduct mortgage interest and real estate taxes on rental properties. If you pay mortgage points, you must amortize them over the term of the loan (unlike points on a mortgage to purchase a principal residence, which can be deducted immediately).

You can also write off all other operating expenses — like utilities, insurance, homeowner association fees, repairs and maintenance, yard care and so forth.

But the real kicker is that you can depreciate the cost of residential buildings over 27.5 years, even while they are (you hope) increasing in value. Say your rental property — not including the land — cost $100,000. The annual depreciation deduction is $3,636, which means you can have that much in positive cash flow without owing any income taxes. That's a pretty good deal, especially after you own several properties. Commercial buildings must be depreciated over a much longer 39 years, but the write-offs will still shelter some cash flow from taxes.

Beware of the Passive Loss Rules
If your property throws off a tax loss — and most do at least during the early years — things get complicated. The so-called passive activity loss, or PAL, rules will probably apply. The fundamental PAL concept is this: You can deduct passive losses only to the extent that you have passive income from other sources — like positive operating income from other rental properties or gains from selling them.

Fortunately, a special exception says you can generally deduct up to $25,000 in passive losses from rental real estate so long as: (1) your adjusted gross income (before the real estate losses) is under $100,000; and (2) you "actively participate" in the rental activity. Active participation means owning a 10% or greater stake in the property and being energetic enough to at least make management decisions like approving tenants, signing leases and authorizing repairs. In other words, you don't have to mow the lawn and snake out the drains yourself to pass the test. But if you use a management company to handle all the details, forget about taking advantage of the $25,000 exception.

If your AGI is between $100,000 and $150,000, the exception is phased out pro-rata. So AGI of $125,000 means you can deduct up to $12,500 in passive real estate losses (half of the $25,000 maximum) even if you have zero passive income.

The bottom line: Rental property owners have to watch their AGI like a hawk. Every $2 over the $100,000 threshold costs a dollar in current passive loss deductions. For example, say your 2005 AGI is shaping up to be right around the $100,000 borderline. You might want to consider year-end planning moves that will reduce your AGI, or at least not cause it to go up. Selling some loser stocks or mutual funds could be a good idea, while selling some winners might only make Uncle Sam happy.

If your AGI is above $150,000 and you have no passive income, you generally cannot deduct a rental real-estate loss. However, your loss carries over to future tax years. You will eventually be able to deduct your carryover losses when you either sell the property or generate some passive income. All in all, this is not a bad outcome as long as you have just "paper losses" caused by your depreciation write-offs.

Two more things about the PAL rules.

First, if your property is in a resort area, the average rental period may be seven days or less. In this case, the IRS says you are running a business rather than a rental operation. (I know this sounds crazy, but I don't write the rules.) Now, if you "materially participate" in running this business, you're exempt from the PAL rules and can deduct your losses currently. So what does it take to materially participate? In a nutshell, you must either: 1) spend more than 500 hours annually taking care of the property or 2) spend more than 100 hours, with no one else spending more time than you do. Remember, this exception applies only if the average rental period is seven days or less. If you use a management company, you will almost certainly fail to meet the participation guidelines. (For more about rental vacation properties and your taxes, click here.)

Second, there's yet another PAL exception that applies only to people who have become heavily involved in real estate. To take advantage of this one you must spend more than 750 hours annually in real estate activities in which you materially participate. And those hours must be more than 50% of the time you spend working for a living. There are some other hurdles as well, but if you clear them, you'll be exempt from the PAL rules and therefore able to deduct your rental losses. What If I Have Income?
Eventually your rental properties should start throwing off positive taxable income instead of losses because escalating rents will finally surpass your deductible expenses. Of course, you must pay income taxes on those profits. But if you piled up some carryover passive losses in earlier years, you now get to use them to offset your profits. So you might not actually owe any extra taxes for a while.

Another nice thing: Positive taxable income from rental real estate isn't hit with the dreaded self-employment, or SE, tax, which applies to most other profit-making ventures other than working as an employee and investing. Depending on your situation, the SE tax can be either 15.3% or 2.9%. In either case, it's a wonderful thing when you don't have to pay it. (Take it from me; I'm self-employed.)

Taxpayer-Friendly Rules When You Sell
When you sell real estate that you've owned for more than a year, your profit — the difference between sales proceeds and basis after reductions for depreciation — is generally considered a long-term capital gain. However, part of the gain — the amount equal to the depreciation — is taxed at a maximum federal rate of up to 25% rather than the normal 15%. Before you complain, remember that those earlier depreciation write-offs probably sheltered income that would have been taxed at 25% or greater. The rest of your gain is taxed at a maximum federal rate of no more than 15%.

Remember, too, that you are able to defer income taxes on rental property appreciation until you sell. Good properties can generate the kind of compounded tax-deferred growth that investors dream about. As you know, this is not so easily done in the stock market these days. You can even pocket part of your gain in advance by taking out a second mortgage against your property or refinancing it with a bigger first mortgage. Is this a tax-free maneuver? You bet.

You also have the option of selling real estate on the installment plan by taking back a note for part of the sale price. Then your taxable gain can be spread over several years. You also get to charge the buyer interest on the deferred payments, but you generally don't have to pay interest to the government on your deferred gains. Can you do this with publicly traded securities? Nope.

Remember those carryover passive losses? You also get to use them to offset gains from selling your properties. So it pays to keep careful track of your losses, even though you cannot deduct them right now.

Finally, the law allows real estate owners to unload appreciated properties while still deferring income taxes indefinitely. Here we are talking about so-called "like-kind exchanges," or "Section 1031 exchanges." Basically what you do is swap one piece of real estate for another, and put off paying taxes until you sell the new piece. Or, when you are ready to unload that property, you can arrange yet another like-kind exchange.

Granted, you're not allowed to actually cash in your real estate investments, but you can certainly trade your holdings in one area for properties in what you deem to be a more promising location. Or you can, for example, exit the rental apartment business by making a like-kind exchange for a strip shopping center, or raw land, or even a golf course or marina for that matter.

See? I told you the tax rules for real estate are pretty darned favorable. Now it's up to you to decide if you want to take the plunge.