Purchasing real estate as investment property can provide substantial tax savings. That said, there are pitfalls to look out for and details to consider in the process of acquiring investment property - especially if you're considering renting the property and deducting expenses and losses from the income generated.

We caught up this month with Sonia Stingo, CPA, PFS, from her office in Wellesley, MA to learn more about what's involved.

ForeclosuresMass: Thanks for your time during tax season! First off, are there special tax rules governing rental activities?

Sonia Stingo: Absolutely. In fact the rules regarding the rental of investment property can be extremely involved, especially when dealing with losses that may have been generated from the rental activity.

FM: Loses generated from rental activity can be claimed on a taxpayer's return, correct?

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SS: It depends. You may be able to deduct as much as $25,000 of rental real estate loss allowance in one year. If the property produces a paper loss after depreciation has been taken into account, the losses can offset other ordinary income on your tax return. Depending on your effective tax rates, you could be looking at a potential tax savings of up to $8,750 on your federal return alone. But, not everyone is eligible for all (or even part) of the allowance.

FM: What are the requirements? What type of taxpayer can deduct the rental loss allowance?

SS: First of all, there are some basic limitations based on your AGI (Adjusted Gross Income) and your filing status:

• If your modified AGI (Adjusted Gross Income) exceeds $100,000, the loss allowance will begin to phase out.
• If your modified AGI reaches $150,000, the allowance is reduced to zero.
• You must "actively participate" in the rental activity. To be considered an active participant, you need to have at least a 10% ownership in the rental property.
• Married-filing-separate taxpayers will have the allowance reduced to $12,500, and in this case AGI limitations begin at $50,000 instead of $100,000.

FM: How about if I consider myself a real estate professional, am I still subject to the $25,000 rental loss allowance limitation?

SS: Again, it depends. You'll first need to be considered a real estate professional in the IRS's eyes, in which case the allowance limitation may be waived under certain circumstances. To achieve this classification, you must meet two tests every year:

1. More than 50% of your personal services during the tax year must be performed in real property, trade or businesses, AND

2. You must spend more than 750 hours of service during the tax year in real property trade or businesses.

Once established as a real estate professional, you then must meet one of several criteria that define material participation in each rental activity. The good news is that if the above tests are met, the $25,000 rental loss allowance limitation does not apply to you!

FM: Can you give us examples of deductions that can be used to reduce rental income?

SS: Sure. Here are some items that can be claimed as a deduction to offset the rent you will receive on the property:

• Mortgage interest
• Real estate taxes
• Insurance
• Utilities
• Maintenance
• Minor repairs
• Condominium fees
• Depreciation
• Advertising
• Travel
• Professional fees

All of the above examples would apply to the portion of the property that was actually rented during the year.

FM: So you're saying that deductions are limited on mixed-use property?

SS: Yes, since if the property in question is only rented part of the time, then the associated expenses are limited to reflect that. Let's say for example, that you own a vacation home, renting it part of the year and using it for yourself during the rest. The key to the limitation of expenses is the number of days the vacation home is used for personal use as follows:

1. If the property is rented for 14 days or less no rental income is recognized and no expenses are allowed.

2. If personal use is no more than the greater of 14 days or 10% of the number of days rented at fair value, then all expenses allocated to the rental portion are allowed and any expense in excess of income is subject to limitations.

3. If personal use is more than the greater of 14 days or 10% of the number of days rented at fair value, deductions are limited to gross rental income, and unused deductions may be carried forward to future years.

FM: Understood. Anything else to add before we let you go?

SS: In addition to the potential tax savings, another benefit to purchasing real estate is that you've acquired an appreciating asset to diversify your investment portfolio. As both a CPA and an Investment Advisor, I believe that a diversified portfolio is the key to financial success!

Sonia M. Stingo CPA, PFS is a partner at Livingston & Haynes, a CPA firm located in Wellesley, Massachusetts. She has been in practice for over 16 years serving clients in real estate and various other industries. She can be contacted at sstingo@lh-cpa.com, 781-237-3339.

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