Last week we looked at the tax benefits residential homeowners get. But what about tax breaks for those who invest in real estate? Well, your Congress has gifts for them, too. I define investors as those who own rental real estate that they plan to hold at least several years.

> Mortgage interest expense is perhaps the largest expenditure real estate investors make. And just as homeowners do, investors get to deduct against income the costs of borrowing money to pay for the property. But the deduction gets better from there. Because you are now in the business of renting your house to a tenant, you may also deduct the cost of property taxes and hazard insurance, both of which are often included in your monthly loan payment. In fact, about the only thing you cannot deduct is that portion of your payment designated as "principal reduction." This explains why many investors tend toward long-term financing, or even interest-only financing. There is less benefit in paying off the loan, as it doesn't lower the payment and it isn't tax-deductible.

> Normal and necessary business expenses are also deductible against the income generated by the property. This would include things like cleaning, maintenance, utilities, management fees, advertising, office supplies, auto and travel expenses, and legal and other professional fees. The Internal Revenue Service expects the costs to be reasonable in relation to the income generated by the investment; it also expects that your goal should be to make a profit, not perpetually lose money. But the underlying concept is you have to spend money to make money, and the IRS wants you to make money so you can pay more tax dollars.

> Another major tax benefit of owning a real estate investment is the deduction you get for depreciation. Depreciation is a way of accounting for the deterioration of an asset over its useful life. In other words, if we are talking about a refrigerator, we can agree that it probably has a useful life of seven years. After that time in rental service, it will likely need to be replaced. So instead of getting a complete deduction for the full cost of a new refrigerator today, the IRS wants you to spread out the deduction over the seven-year life of the refrigerator. The IRS has set statutory useful lives for different types of assets, including refrigerators and houses.

The IRS has decreed that the useful life of a house is exactly 27.5 years. So if you bought a rental house for $100,000 and placed it in rental service on Jan. 1, and if you determined that the value of the lot was about $18,000 (from tax records and comparable sales), then the value of the improvement (the house) would be fixed at $82,000. And if you left that house in rental service for a full year, you would show a "non-cash" expenditure on your tax return for that year of ($82,000 divided by 27.5 years) almost $3,000.

Why is this helpful? Because many rental property owners find their income from rent almost exactly equals their out-of-pocket expenses for the year. And in the early years of rental ownership, that is not unusual. But by adding a $3,000 depreciation deduction to the mix, the investor can show a "paper loss" for the year, and possibly apply that loss against other taxable income. It's a way of lowering the amount you have to pay in income taxes, and it's called a tax shelter.

Adjusting the years allotted for depreciation is a way of rewarding (or discouraging) real estate investment. So in the early 1980s when Congress wanted to jump-start the economy, it introduced accelerated depreciation, designed to give investors much bigger tax deductions for depreciation in the early years of ownership. Today, depreciation on residential houses is limited to 3.63 percent of the improvement (the house only) per year. So, here is a rule of thumb that many investors use to predict the amount of their tax shelter:

If all my property breaks even on a cash-flow basis, and if I get about a $3,000 tax shelter for each $100,000 of real estate that I place into rental service, then I can zero out my tax bill on $24,000 of regular job income by owning approximately eight rental houses that I purchase for about $100,000 each.

Next week: Tax-deferred exchanges for investors only.

Find more articles by John Adams online at ajchomefinder.com.