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All About Rents, Costs and Taxes

By Jeffrey R. Kosnett, Senior Editor, Kiplinger's Personal Finance, Source: Kiplinger Consumer News Service

On the income side of the ledger. Buyer's agent David Stephens says you could probably rent the home for 36 weeks at an average rent of $3,400, for total rental income of $122,400. That assumes you don't have to cut rates too often to lure last-minute guests, and nobody calls off a wedding or other big-ticket event. (Any seller or real estate agent should be able to give you several years of rental history. Failure to do so is a deal breaker.)

On the expense side. If you borrow $420,000 for 15 years at 6% -- excellent terms in today's tight credit market -- you're writing $42,500 worth of checks to the lender each year.

Overhead for taxes, utilities, cable, Internet, repairs and other routine maintenance will easily run $15,000 to $20,000 a year, perhaps more. Let's call it $20,000.

Even if you live near the home, you may have neither the ability nor the inclination to handle the property on your own. So you'll probably hire a property manager, who will help with bookings, cleaning and minor repairs. But you'll pay 30% to 40% of the rent for the help. Assuming 35%, there goes $42,840.

Out-of-pocket cost: $105,340. Then there's the forgone income on the $180,000 down payment. Stashed in a portfolio of tax-free bonds, that amount would earn $7,200 a year.

Total cost: $112,540.

Bottom line: A profit of just under $10,000. Just a few unexpected vacancies could erase that small gain. (You can see why the deal wouldn't work if you had paid a bubble-era, seven-figure price for the home.)

But wait ... Won't Uncle Sam's tax breaks transform this into a great deal? Not really.

Many potential real estate investors have a wildly exaggerated idea of how much help they'll get from the IRS. Sure, legitimate rental expenses -- including those listed above -- can offset rental income so that you don't have to pay tax on it. Plus, you get to deduct depreciation, a noncash expense that can turn a taxable profit into a money-saving loss on your tax return. But there are a couple of tripwires to avoid.

First, to deduct a rental loss on your return, you must treat the house as a business, not a personal residence. The key to this is to limit personal use to 14 days per year or 10% of the total number of days the home is rented out, whichever is longer.

Second, you might not get to claim the loss even if you follow the rules. Another section of the tax law limits rental losses to no more than $25,000 a year -- and denies them altogether if your adjusted gross income exceeds $150,000. (These so-called suspended passive losses can be used in the year you sell the property to offset the profit on the deal or other income.)

So you can't depend on tax breaks to turn your real estate investment into a sure thing. What you can expect is big fixed costs and income that's totally variable.

All contents copyright 2008 The Kiplinger Washington Editors, Inc.