Purchasing real estate as investment property can provide you with some substantial tax savings. However, there are a few pitfalls to look out for in your process of acquiring investment property.

Special Tax Rules for Rental Activities

Once you acquire the property, do you plan on charging rent on the real estate?

Some individuals can deduct up to $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. However, there are some limitations on the losses as follows:

1. If the taxpayer's modified AGI (Adjusted Gross Income) exceeds $100,000, the loss allowance will begin to phase out.
2. The allowance is reduced to zero when modified AGI reaches $150,000.
3. The taxpayer must "actively participate" in the rental activity. Active participation requires at least a 10% ownership in the rental property.
4. Married-filing-separate taxpayers will have the allowance reduced to $12,500 with AGI limitations beginning at $50,000 instead of $100,000.

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It is possible that the rental loss allowance will be waived under certain circumstances, such as qualifying for the classification of a real estate professional. To determine if you can be classified as a real estate professional in the IRS's eyes, you must meet two requirements 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 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 must meet one of several criteria that define material participation in each rental activity. One example of these criteria is if the taxpayer participates in the activity on a regular, continuous and substantial basis during the year, and participates more than 100 hours.

The good news is that if the above requirements are met, the $25,000 rental loss allowance limitation does not apply to you!

What Expenses Can Be Used to Offset Rental Income?

Here are some of the 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.

Mixed-Use Property

Expenses can be limited on mixed-use property depending on the extent of personal use by the taxpayer. A basic example of mixed-use property is a vacation home that is used by the taxpayer personally and rented during the year as well. The key to the limitation of expenses is 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.

In addition to the potential tax savings, another benefit of 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 always like to see that combination!

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 or 781-237-3339.