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September 13, 2007

Rather than sell, should you lease your home?

If you're having trouble selling your home in the current housing slump, it might make more sense to lease it instead.

Doing so could turn your property into a rent machine and open up extra tax breaks. Plus, it would buy time until market conditions improve.

But renting a home isn't a slam-dunk strategy. Not everyone has the financial reserves, time, expertise or disposition to do it right. And understanding the tax benefits is crucial.

"It's not as simple as just setting out a 'for rent' sign," said Stephen Phillips, a Phoenix resident who owns rental properties in Phoenix and San Diego with his brother. "You need a tolerance for calls at 10:30 at night."

Landlords emphasize the need to operate rental properties like any other business, in an emotionally detached way.

"You can't get sucked into everyone's hard-luck tale," Phillips said.

It's also critical to learn about landlord-tenant laws and credit and background checks for applicants. Another requirement is developing a network of handymen, plumbers, electricians and the like.

You should know how to keep good records. For example, it's smart to maintain separate checking accounts for each property, Phillips said.

It's also advisable to keep at least a few thousand dollars in reserve for unanticipated problems.

Jeff Young, a Scottsdale, Ariz., investment adviser and owner of two rental units, cautions prospective landlords not to assume they'll earn a positive cash flow, especially if they bought at a lofty price.

"Rents aren't necessarily going to pay all the bills, even if you made a 20-percent down payment," he said. "You'll have to count on the tax benefits, and you'll need time."

The tax benefits of owning a rental property differ from those for primary residences.

On both, mortgage-interest and property-tax expenses can be deducted. But landlords also can write off many costs for repairs, maintenance and property managers and take a deduction for depreciation

"Think of it as a small business," said Jim Darling, a certified public accountant at Jenner & Darling in Tempe, Ariz. "Everything you spend is deductible, one way or another."

The tax treatment of capital gains and losses also differs.

When owners of a rental property sell, they can defer capital-gain taxes by switching to another property through a transaction called a 1031 tax-free exchange. Owners who don't make this reinvestment, or do it incorrectly, will owe taxes.

When homeowners sell, they can exclude up to $250,000 in profits ($500,000 for married couples) on a primary residence without having to reinvest in other real estate. To qualify, they must have owned and used the home for at least two years over the five years ending on the date of sale.

They can get a partial benefit even if they don't meet the two-year use and ownership tests if they were forced to sell by various events, including being transferred to a job in a different area or undergoing a divorce.

One tax trap that can trip the unwary is renting out a home that the owner formerly occupied as their primary residence. Doing so could wipe out that $250,000 or $500,000 tax break, which isn't available on rentals.

Rentals also differ from primary residences in the treatment of losses. Landlords can deduct a loss on rentals they sold for less than they paid (adjusted for improvements and a few other factors). Homeowners can't deduct a loss on a primary residence, even if they later rent it out.

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