So You Want to Be a Landlord

But those willing to take that risk could reap 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.

I can't help you figure out whether you've got the patience and fortitude to be a landlord. 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 current-year 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.