Falling prices have created a buyer's market in housing. The same trends might encourage you to shop for a home that you can rent to tenants. Rents may firm as more would-be home buyers are denied mortgages and rent homes instead. What's more, tax breaks for real estate investors can make such ventures attractive.

Sheltered cash flow
Owners of investment property are entitled to some non-cash deductions, such as depreciation. These deductions help you avoid tax on any net rental income you receive.

To see how this might work, suppose that you buy a house that you rent for $2,000 per month. That's $24,000 per year. Also suppose that your expenses add up to $19,000 per year. You would put $5,000 into your pocket. However, you might have a $9,000 depreciation deduction in this hypothetical example. Now you'd have a $4,000 loss, for tax purposes. With a taxable loss, you'd owe no tax. Thus, your $5,000 in cash flow will be tax free, sort of.

Paying the price
Is this tax-free cash flow really tax free? Not exactly. Depreciation deductions lower your basis in the property. A lower basis, in turn, will increase your tax on an eventual sale. Fortunately, the tax on prior depreciation deductions is capped at 25%. Thus, you may defer tax normally owed at rates up to 35% and pay it years later at a 25% rate.

There is actually a way to avoid paying tax on the depreciation deductions you've taken. Under current law, assets such as real estate get a basis step-up to market value when they're left to heirs. Therefore, if you hold on to investment property until death, your heirs can sell the property for its current value and owe no capital gains tax. All the tax-free cash flow you received during your lifetime will never be taxed.

Win from losing
In the example above, you wound up with a $4,000 loss, for tax purposes. Such a loss might be deductible, depending on your adjusted gross income (AGI). Losses from rental properties are known as passive losses. If your AGI is no more than $100,000, passive losses are deductible, up to $25,000 per year.

Over $100,000, this deduction is phased out. Say you own a rental property with a tax loss and your AGI is $120,000. You are 40% of the way through the $100,000 - $150,000 phaseout range, so your maximum passive rate deduction is 60% of $25,000: $15,000. If your AGI is $150,000 or more, you generally cannot deduct passive losses.

Loss carry-overs
If you have passive losses that you can't deduct right away, they may be carried forward to future years indefinitely. Those losses can be used to offset any taxable income you might have from rental properties. If you haven't used your passive losses by the time you sell the property, they will be deducted against your ordinary income in the year of sale. If you have a gain on the sale, favorable capital gains rates will apply.

An active approach
The tax laws described above relate to passive losses. You losses won't be passive if you are a real estate professional. To be treated as a real estate professional, you must spend more than half your working time on real estate - at least 750 hours a year. Then you can deduct any losses from rental property right away, regardless of your AGI.

 

Limits on Passive Activity Loss Deductions
Adjusted Gross Income	Maximum Annual Deductions
Up to $100,000	$25,000
$110,000	$20,000
$120,000	$15,000
$130,000	$10,000
$140,000	$5,000
$150,000 or More	0
Source: www.webtax.com