So you want to be a real-estate investor?
By Robert Bruss
Tribune Media Services
     Are you a real estate investor? Do you want to be?
     Perhaps you're not aware of all the real estate investment tax benefits. Rental houses, apartments, offices, warehouses, commercial buildings, shopping centers and even vacant land offer tax benefits during ownership and at resale time.
     Most people invest in real estate for its potential to increase in market value. Another major reason to invest is because it's usually possible to acquire investment property with small down payments, typically 10 to 20 percent, and to use leverage to benefit from probable profits. Still another reason for acquiring investment property is the tax shelter benefits during ownership.

 Some investors have unlimited tax deductions
     You can qualify for unlimited tax deductions from your real estate investments if you spend at least 750 hours per year, or more than 50 percent of your working time, in real estate activities. Most real estate brokers, realty salespeople, rental agents, developers, builders, contractors, property managers and leasing agents easily qualify.
     However, the tax law says real estate attorneys and mortgage brokers cannot qualify for unlimited tax deductions from their investment properties. They, and all others who are not considered real estate professionals by the Internal Revenue Service, are limited to a maximum of $25,000 in annual realty loss deductions from investment properties, offsetting their other ordinary taxable income.

Property management 'material participation' is required
     To qualify for the ``unlimited deduction'' realty investment category, ``material participation'' in the property management is required. That means you must make at least the major decisions about managing your property, such as setting rents, approving new tenants and making major expense decisions. However, you need not be involved in the daily details, such as collecting rents and evicting deadbeat tenants.
     If you are a ``real estate professional'' who spends at least 750 hours a year, or more than 50 percent of your working time, in real estate activities, and you materially participate in managing your properties, then there is no limit to your tax shelter deductions from your realty investments.
     However, if you can't qualify, then your realty investment deductions against your ordinary taxable income are limited to $25,000 if you earn less than $100,000 annual adjusted gross income. For example, if you are a dentist and spend most of your time practicing dentistry, yet you own several rental houses, your deductible annual tax losses from property investments are limited to $25,000.

Depreciation is the biggest ownership realty investment benefit
     Most realty investors are happy if they have breakeven or slightly positive cash flow from their rental properties. The reason is, after claiming their income tax savings from deductions, they will usually show a paper profit.
     Most realty investment tax deduction losses are not actual out-of-pocket cash losses, where expenses exceed rental income. Instead, most realty tax benefits are due to ``paper losses'' (but not actual cash losses), due to the depreciation tax deduction.
     Depreciation is a noncash bookkeeping deduction for estimated wear, tear and obsolescence. Although the property is probably appreciating in market value, depreciation tax deductions are allowed for investment properties.
     Residential rental properties must currently be depreciated over 27.5 years on a straight-line estimated useful life. Commercial properties require a 39-year depreciation schedule. But non-residential properties placed in service before May 13, 1993, can be depreciated over 31.5 years. With most properties, the result after deducting depreciation shows a tax or paper loss (although they often show a positive cash flow at the same time).

Two tests are required for passive activity tax-loss deductions
     Unless you're entitled to unlimited realty investment deductions, as explained above, as a part-time investor claiming up to $25,000 annual passive activity deductions against your ordinary taxable income, you must pass two tests:
     1 -- You must materially participate in property management decisions, such as tenant selection, rent setting and other major management decisions. To illustrate, if you own a vacation condo in a resort ``rental pool,'' managed by on-site professionals, you don't qualify since you aren't involved in daily management decisions. However, if you must be consulted by the property manager to set the rent, approve tenants and make repair decisions, then you materially participate.
     2 -- You must own at least 10 percent of the investment property. This tax rule excludes most real estate limited partners from claiming investment property deductions against their ordinary income.

Unused passive activity deducations can be saved for future use
     If you don't materially participate in your investment real estate's management or if your realty investment tax deductions exceed your other taxable income, you can save or ``suspend'' unused tax deductions for future use.
     But such unused tax losses cannot be carried back to previous tax years to claim a tax refund. IRS Notice 88-94 allows these suspended passive activity losses from investment real estate to offset sales of such properties in future years. The major tax benefit is that property losses and gains are taken on an aggregate basis, rather than property by property.

Watch out for recaptured depreciation when property is sold
     Realty investors received a major tax benefit from the 1997 Tax Act, which reduced long-term capital gains taxes to 20 percent for most taxpayers. Low-income taxpayers pay even lower capital gains tax rates.
     But a special 25-percent tax rate applies to depreciation recaptured or taxed at the time of sale. For example, suppose you bought a rental house in 1997 for $100,000 and deducted $5,000 of depreciation deductions while you owned it. In 2000 you sold the rental house for $150,000 net. Your capital gain is the difference between $150,000 and your $95,000 adjusted cost basis ($100,000 minus $5,000 depreciation deducted). This profit will be taxed at 25 percent on the $5,000 recaptured depreciation and at 20 percent on the remaining $55,000 profit. For more details, please consult your tax adviser.