real estate discussion question ( 150 words minimim)

February 4, 2007

SQUARE FEET | VENTURES

Reaping the Tax Benefits From Rental Property

By VIVIAN MARINO

ONE benefit of owning rental real estate is the myriad tax breaks. More deductions and tax-related strategies

are available for this property than for just about any other type of investment. Not all owners, however, take

full advantage of these allowances, either because they don’t know about them or choose to ignore them,

perhaps out of fear of an audit.

“A lot of deductions people may overlook,” said Stephen Fishman, a tax lawyer from San Francisco and the

author of “Every Landlord’s Tax Deduction Guide” (Nolo, 2006), “and that can really add up.”

There are, of course, the obvious ones like mortgage interest and operating expenses like insurance. But some

people may not know that they can also deduct expenses when conducting real estate business at home, or

that there are different ways to depreciate the cost of their property even as its value increases.

“There are a lot of landlords out there right now,” Mr. Fishman said. Some of them are accidental landlords

who were caught up in the real estate frenzy and now have properties they cannot sell.

The Internal Revenue Service advises all of them to keep detailed records of all rental-related activities,

including receipts and invoices. All of that is reported on Schedule E, Supplemental Income and Loss.

(Software programs like Quicken Rental Property Manager or Tenant Pro can help organize all the records,

cutting back on the tax-preparation time.)

For Christine H. Karpinski of Austin, Tex., and her husband, Thomas, staying organized means treating their

rental activity as the business it is and keeping separate credit cards and bank accounts for their

condominiums and cabins in Florida and Tennessee. The couple also ensure that their properties remain

rentals, which typically means renting them out for more than 14 days a year and using them personally for

no more than 14 days or 10 percent of the total rental days, whichever is greater.

Mrs. Karpinski says all her records and tax information are now being turned over to an accountant. “The

better the books you keep throughout the year,” she said, “the easier your life will be come April 15.”

As the tax season unfolds, here are some areas where you can focus, whether you’re a neophyte landlord with

one property or a seasoned investor with many properties:

Depreciation

Mr. Fishman calls depreciation one of the best tax tools for a landlord, because it basically allows you to write

off your biggest expense: the purchase price for the rental property — not including the land — or, in I.R.S.

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parlance, the “cost basis.” Depreciation also reduces your basis for calculating the gain or loss on a later sale

or exchange.

Depreciation takes place over time — or, rather, on the I.R.S.’s schedule. If you depreciate a building and its

contents as a whole, it must be done over 27½ years for a residential rental property and 39 years for a

commercial property.

If you paid, say, $300,000 for a property (after subtracting the land value), the annual depreciation would be

$10,909, which means that you can have a positive cash flow up to that amount without owing any income

taxes.

To help speed things up, some landlords might consider a strategy known as cost segregation, Mr. Fishman

noted. Components of a property and its improvements are depreciated separately, often with different,

shorter timelines. Furniture and appliances, for instance, are depreciated over five years.

Improvements and Repairs

Property improvements are also included in the cost basis and are depreciated over time, though the cost of

most repairs is deductible in the year when it is incurred.

So how do you tell the difference between an improvement and a repair? Julian Block, a tax lawyer from

Larchmont, N.Y., and a former I.R.S. special agent, explained that “improvements add to the value of a

property — they prolong the useful life or adapt it to new uses — whereas a repair maintains your property in

good condition.”

He also warned, “You can deduct the supplies, but you cannot assign a value to your own labor and take a

deduction on that.”

New for the 2006 tax year is the energy-efficiency deduction, which lets you deduct the cost of making a

commercial building more energy-efficient. The amount deductible may be as much as $1.80 a square foot

for buildings that achieve a 50 percent energy savings target.

Operating Expenses

Routine expenses that keep a property operational shouldn’t be overlooked, and it is crucial to keep an

accurate accounting of them.

For starters, you can claim deductions for financing a rental property, including mortgage interest payments,

even private mortgage insurance. You can also deduct interest on loans for improvements and the interest on

credit cards used as part of your rental activity.

There are allowable deductions for local property taxes, insurance, property management fees, advertising

and utilities — assuming that the tenants don’t pay them. Then there are deductions for property association

dues, landscaping and garbage disposal, among others.

“If it’s just a second home, that’s money out the window; you can’t write it off,” said Mrs. Karpinski, who is

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also the author of “Profit From Your Vacation Home Dream” (Kaplan Business, 2005).

All deductible expenses must be what the I.R.S. deems as ordinary and necessary.

Travel

Some landlords may not know that they can deduct travel expenses associated with their rental property,

whether they involve driving cross-town or flying cross-country.

For local travel, you can deduct the actual expenses — gasoline, upkeep, repairs — or use the standard

mileage rate, Mr. Block said. The standard rate is 48½ cents a mile this year and 44½ cents for 2006. Tolls

and parking are also deductible, he said.

For overnight travel, you can deduct airfare and hotel bills, and part of your meals and other expenses. You

might even be able to mix business with pleasure if you properly prorate and document the business

expenses. Mr. Fishman warned that I.R.S. auditors often scrutinize these deductions.

Home Office

If rental business is conducted out of your home, you may be able to deduct certain expenses, including a

portion of utilities, homeowner’s insurance and even interest on your home mortgage.

To qualify, the office or work space must be the principal place of business, where, for example, you might

meet prospective tenants. It can be inside a house or in a detached structure on the same property, or even in

an apartment you rent, provided that it is your primary residence.

“It doesn’t have to be an entire room; it can be a definable part,” Mr. Block said.

Keep in mind that the space must be used exclusively for your business and for no other purpose. That means

that your children can’t also be playing computer games there. (The deductions are reported on Schedule C

with Form 8829 attached.)

Some people are wary of taking this deduction out of concern of attracting unwanted I.R.S. attention, noted

Mr. Fishman, who is also the author of “Home Business Tax Deductions” (Nolo, 2006). But there are ways to

“audit proof” the deduction, he says in his book — by keeping pictures or diagrams of the home office, for

example, and maintaining a log of all the time spent working there.

Even if you don’t meet the home-office criteria, you can still deduct ordinary business expenses that you

incur at home. like long-distance phone calls and office supplies, he added.

Unexpected Losses

If your rental property is damaged or destroyed in a sudden event — say, a fire or a flood, you may be able to

deduct all or part of a loss. The same holds true for property that is stolen or vandalized. The deduction

amount will depend on the extent of the damage and the insurance coverage, tax experts say.

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Tax Losses

There are deductions if your building or unit produces a tax loss, as is the case with many rental properties

early on, but here is where the situation can become thorny. As Mr. Block explained, you can record only

losses that are offset by passive income. All of your rental activities are generally considered passive, unless,

of course, you are a real estate professional like a developer or property manager.

But the tax law does provide greater relief for people who can be defined as “active managers,” who do things

like vet tenants or set rents, Mr. Block said. Active managers can deduct up to $25,000 in rental losses

against other types of income like dividends and salary, he said, although this break phases out when

adjusted gross income exceeds $100,000 and vanishes entirely when it reaches $150,000.

“Some people will implement tax strategies just to keep their income below $150,000,” Mr. Block said, like

making deductible contributions to qualified retirement plans.

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