Tax breaks for real-estate losses

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(FORTUNE Small Business) -- Dear FSB: I own three rental properties, and am trying to hang on to them as the real estate market is bad here. Each month I have to pay out of pocket to cover the mortgage. Can I claim this loss on my taxes - and is there a limit?

Also, I have an S-Corp. Should I put all the rentals under the S-Corp or create an LLC for each rental?

- Robin Dion, Miami, Fla.

Dear Robin: In general, tax law does limit the extent to which you can deduct losses from rental real estate and other so-called "passive activities."

Your rental real estate deductions can be taken only against "passive activity" income - such as the rent you charge your tenants - and not other income sources like wages, royalties and dividends, says tax attorney Terry Perris of the international firm Squire, Sanders and Dempsey, LLC.

So, the dollar amount of losses you deduct is limited each year to your total passive-activity income. However, if you have more losses than you can deduct, you can "suspend" the excess to take against future passive activity income - or against the proceeds when the property is disposed of.

Remember also that only the portion of your mortgage that goes toward interest is tax-deductible, and not the principal, Perris said.

There are two exceptions to this deduction limit. The first is referred to as the "real estate professional" exception, and applies if more than half of your professional hours are spent on rental real estate and you perform more than 750 hours of this type of service each year, says tax attorney Brian Whitlock of Chicago, Ill.-based Blackman Kallick.

The other exception allows up to a $25,000 annual deduction, as long as you actively participate in making management decisions, such as arranging for repairs or approving new tenants, said Perris.

However, this latter exception phases out on a scaled basis for individuals whose adjusted gross income exceeds $100,000, says Cristina Perez of Coral Gables, Fla.-based accounting firm De La Hoz & Associates.

The exception is not available at all to those with AGIs of $150,000 or greater, Perez says.

The S-Corp Route
Neither Perris nor Whitlock recommends putting your rental real estate into an S-Corp., as you won't be able to remove the properties from the S-Corp. later without being subject to tax liability on any built-in gains.

"The corporation rules are highly complex and can be fraught with tax traps," Whitlock said. "Limited partnerships and LLCs that are taxed like partnerships are usually better vehicles for holding real estate."

For example, should you put the three properties into an LLC - or each into individual LLCs - you likely won't incur any tax liability upon removing them, Perris said.

Using an LLC may also protect you from personal liability that arises from ownership of the properties, Perris said.

Separating each property into individual LLCs may be more complex than holding all of them in one, but it would offer the potential to protect each piece of real estate from liabilities that arise from the other properties, Perris said.

Disclaimer: This column provides general information only and is not intended to replace the services or legal advice of an attorney or CPA. Always consult a lawyer or accountant regarding specific legal or financial issues.