Second Home - So You Want to Be a Landlord

It seems like everyone is buying real estate as an investment. Some may plan to flip the property quickly and make a large profit in a short time period. Others have a different plan - they want a rental property.

Being a landlord has some significant tax advantages. The favorable IRS rules are why many fortunes have been made in real estate.

The biggest downside to being a landlord is the tenants. And you have to have them. The biggest risk is that if both real estate and rental prices decline, you could lose money on your investment.

Here's what you need to know about becoming a landlord:

You can write off

You already know that you can deduct the mortgage interest and real estate taxes on your rental properties. If you pay mortgage points on a rental, you must amortize them over the term of the loan. You also have the ability to write off all operating expenses, including: utilities, insurance, homeowner association fees, repairs and maintenance and other expenses.

But you may not know that you can depreciate the cost of residential buildings over 27.5 years, even in they are increasing in value. If your rental property cost $100,000 it will have an annual depreciation deduction of $3,636, which means that you have that much positive cash flow before you owe income taxes. That's a nice benefit, especially if you own several properties. Commercial buildings are depreciated over 39 years, but the write off still shelter some cash from taxes.

Passive Loss Rules hit hard

If your property has a tax loss, as many do in the first few years, things may get complicated. Passive activity loss, or PAL, rules may apply to you. The fundamental concept is that you can deduct passive losses only in the amount that you have passive income from other sources, such as positive operating income from other rental properties or gains from selling.

There is a special exception that allows you to deduct $25,000 in passive losses from real estate as long as you have an adjusted gross income under $100,000 and you actively participate in the rental activity. Active participation means that you own at least 10% of the property and you take an active management role, like improving tenants, signing leases or authorizing repairs. If you use a management company to manage your property, you can't take the exception.

There is a phase out if your adjusted gross income is between $100,000 and $150,000. If you have an AGI of $125,000, you can deduct up to $12,500 in passive real estate losses even if you have zero passive income.

Rental property owners must watch their AGI very closely. Every $2 that exceeds the $100,000 limit costs you a dollar in current passive loss deductions. If your AGI is pushing the line, you might want to plan steps to reduce your AGI or moves to keep it steady.

If your AGI is over $150,000 and there is no passive income, you can't really deduct a rental real estate loss. But you can carry your loss over to future tax years. You can eventually deduct your carryover losses when you sell the property or generate passive income.

There are two more things you need to know about PAL rules:

The first is that if your property is in a resort area, the average rental period may be seven days of less. In this case, the IRS considers you as running a business rather than renting a property out. If you materially participate in running the business, you are exempt from PAL rules. To materially participate, you must either spend more than 500 hours each year taking care of the property or spend more than 100 hours with no other person spending as much time on the property as you do. Remember, this applies only if your rental period is seven days or less.

Secondly, if you are heavily involved in real estate you may qualify for another PAL exception. You must spend more than 750 hours each year in real estate activities. Those hours must be more than 50% of the time you spend working for a living. There are other hurdles as well, but you may find that you are exempt from PAL rules and able to deduct your rental losses.

What about my income?

Over time, your rental properties will begin to give you positive taxable income instead of losses. This is due to the fact that rising rents will eventually surpass your deductible expenses. You have to pay income on these profits. If you've piled up any carryover passive losses, you can now use them to offset your profits. This could save you from owning any extra taxes for a while.

You do have a break: positive taxable income from real estate isn't taxed as self-employment tax.

Rules that are taxpayer friendly

When you sell real estate that you have owned over a year, the profit is considered a long-term capital gain. However, the part of the gain equal to the depreciation will be taxed at a maximum federal rate of up to 25% rather than the normal 15%. It may sound bad, but the earlier depreciation write offs probably sheltered income that would have been taxed at over 25%. The rest of the gain is taxed at no more than 15%.

Remember, that you are able to defer income taxes until you sell the property. Good properties generate tax-deferred growth that investors are looking for. This is not easily done in the stock market. You can even pocket part of your future gain by taking out a second mortgage against your property or refinancing it for a larger amount. This is a good tax-free maneuver.

You can also sell the real estate on an installment plan by taking back a note for a portion of the sale price. Then your taxable gain is spread out over several years. You can even charge the buyer interest on the deferred payments without having to pay interest to the IRS on your deferred gains. This isn't something you can do with publicly traded securities.

Finally, you can unload appreciated properties while still deferring income taxes forever. This is called a "like-kind exchange" or "Section 1031 exchange." All you do is swap one piece of real estate for another. You can then put off paying taxes until you sell the new property. You can keep exchanging and defer the taxes indefinitely.

While you can't cash in your real estate investments, you can trade your property for another in a more promising location. You could exit the rental business for a strip shopping center or raw land for a golf course or even a marina.

The taxation rules for real estate can be favorable; you just have to watch all of your losses and gains.