I have received a number of questions regarding rental real estate and the associated tax laws. Let's look at some of the basics.

The Good News:

1. Interest and taxes on the rental property are fully deductible.
2. You don't have to itemize deductions in order to claim rental losses. Rental losses are different than itemized deductions, and are used on the front of the tax return as an adjustment to income to arrive at adjust gross income (AGI).

The Better News:

1. Condo maintenance fees are fully deductible against rental income.
2. Any other ordinary and necessary rental expenses are deductible against rental income (i.e., advertising, insurance, repairs & maintenance, utilities, etc.).
3. You are able to depreciate the property and secure a non-cash deduction.

The Bad News:

1. Rental properties are considered passive activities. Generally, passive losses are restricted and can only be used against passive income, but those individuals who actively participate in the operation of the rental are given a $25,000 deduction allowance.

2. If your AGI is above $100,000, the $25,000 is reduced by 50% of the AGI in excess of $100,000. Therefore, the allowance is reduced to zero when AGI reaches $150,000. What this really means is that if your AGI is greater than $150,000, your rental losses would NOT be currently deductible, but would be suspended into future years. If you income is between $100,000 and $150,000, your rental losses will be restricted. If you find yourself with AGI of greater than $100,000, make sure that you receive professional tax advice prior to undertaking any rental activity. There's no way I can explain the passive loss rules here.

3. The depreciation that you take on the property reduces the basis (or cost) of the property. So the longer you depreciate the property, the less "cost" you will have in the property, and the greater the ultimate taxable gain on the sale of the property.

4. Unlike a personal residence, you cannot "rollover" the gain on the sale of a rental property and "reinvest" it into another rental property. You can trade the rental for another rental (using a section 1031 exchange), but once you sell the property, taxes will be due.

The Example:

1. Single taxpayer, no dependents, standard deduction
2. AGI before considering the rental property of $40,000.
3. Purchase Price of Rental Property of $85,000.
4. Annual Rental Income: $7,200.
5. Annual Interest and Property Tax Expense: $8,400.
6. Annual HOA Fees, Insurance, Repairs, Advertising, etc.: $2,000.
7. Property has a depreciable basis of $68,000 (remember that land CAN'T be depreciated), and has an annual depreciation allowance of $2,370 (based on MACRS depreciation tables, 27.5 years, straight line, mid month convention, first year).

A quick look shows an annual rental tax loss in the amount of $5,570, of which $3,200 is in real live dollars and $2,370 represents depreciation expense. The tax situation is as follows:

Sooooo... the tax savings on the rental amounts to $1,568, or just a little less than half of the dollars that we had to spend to obtain the deduction ($3,200). Doesn't look like a very good deal from a cash on cash standpoint, does it? We are really $1,632 poorer. Should that be the end of the analysis? Certainly not, not by a long shot. How fast is property appreciating in the area? The annual appreciation might make up for the cash loss. How quickly are rents growing in the area? In my area (Phoenix), the same property that produced $10,200 in rental income last year will produce $11,700 in rental income this year (almost a 15% increase in just one year). Do you have the "stuff" to be a landlord? Is the non-cash depreciation shelter enough to make the deal feasible? Do you have a relative that might be interested in renting the property, thereby helping out the family and generating a deduction at the same time?

Remember that the Tax Reform Act of 1986 made real estate much less of a "killer" tax shelter than it had been prior to that time. You really must investigate all aspects of the rental and the corresponding economic viability of the project. Don't simply think that the tax savings aspect of the deal will make rental property a "good investment." Do your homework. Run all of the numbers. Make your own projections. After all of that, make your own Foolish decision.

And if you DO decide to become a landlord, hope and pray that you don't get the ol' "the toilet is backed up and the bathroom is flooded" call on New Years Day, just minutes before the big game.

For additional information about taxes and rental real estate, call the IRS at 1-800-TAX FORM, or visit their web site at: http://www.irs.ustreas.gov and get IRS Publication 527, "Residential Rental Property."

- Article 22

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