ARE YOU SURE

? I have clients who regale me with stories about their fun experiences with tenants. Like the one who took everything that wasn't bolted down when he moved out. Carpeting, curtain rods, towel bars, the whole nine yards. In fact, he even took one thing that was bolted down -- a toilet, believe it or not.

Indeed, putting up with tenants' antics can be a real pain. But any discomfort is greatly eased by a bunch of juicy tax breaks. In fact, favorable IRS rules are one big reason so many fortunes have been made in real estate. The other big reason is that leveraging real estate investments with mortgages multiplies your upside potential.

But let's stick to taxes. Here are the most important things for budding landlords to understand.

What You Can Write Off
I'm sure you already realize you can deduct mortgage interest and real estate taxes on rental properties. However, 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).

In addition, you can write off all the other operating expenses -- like utilities, insurance, homeowner-association fees, repairs and maintenance, yard care and so forth.

The real kicker is that you can also depreciate the cost of residential buildings over 27 1/2 years, even while they are (you hope) increasing in value. Say your rental house -- not including the land -- costs $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 writeoffs will still shelter some cash flow from taxes.

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 (PAL) rules will probably apply. The fundamental PAL concept is this: You can only deduct passive losses to the extent of passive income from other sources -- like positive operating income from other rental properties or gains from selling them.

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 such as 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 an 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 1999 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 really good idea, while selling some winners may only make Uncle Sam happy.

If your AGI is above $150,000 and you have no passive income, you generally cannot currently deduct a rental real estate loss. However, your loss carries over to future tax years. You will eventually be able deduct your carry-over 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 just have "paper losses" caused by your depreciation writeoffs.

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 over 500 hours annually taking care of the property or 2) spend over 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, see our Tax Guide article

Second, there's yet another PAL exception that applies only to people who have become really heavily involved in real estate. To take advantage of this one you must spend over 750 hours annually in real estate activities in which you materially participate. And those hours must be over 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 be able to currently 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 carry-over passive losses in earlier years, you now get to use them to offset your profits. So you may not actually owe any extra taxes for a while.

Another nice thing: Positive taxable income from rental real estate is not hit with the dreaded self-employment (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 over a year, your profit -- the difference between sales proceeds and basis after reductions for depreciation -- is generally considered a capital gain. However, part of the gain -- the amount equal to the depreciation -- is taxed at a maximum rate of 25% rather than the normal 20%. Before you complain, remember that those earlier depreciation writeoffs probably sheltered income that would have been taxed at 28% or higher.

The rest of your gain is taxed at a maximum of 20%.

Remember, too, that you are able to defer income taxes on rental-property appreciation until you actually 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. 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 an installment plan by taking back a note for part of the sale price. Then your taxable gain can be spread over several years. This could really work out great if Congress once again lowers capital gains taxes in the relatively near future. 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 carry-over passive losses? You also get to use them to offset gains from selling your properties. So it definitely 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," a.k.a. "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 are 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.