Taxing Issues Abound
With Rental Properties

Question: I am looking for a way to use real-estate investments as part of a tax-saving strategy. I make more than $100,000 a year, so I understand that there is no real tax advantage of purchasing a rental property to write off the full amount of mortgage interest. Because of this, I am thinking about buying a property that has a main house and an accompanying guesthouse so I can rent out the main home and use the guesthouse as my second home. What are the tax rules that affect this approach? Is it true that the rental property needs to be at least 10 miles from my main residence? And how many months do I have to live in the second house each year to recognize all of the tax benefits?

-- Peter, Modesto, Calif.

Peter: Your desire to save on taxes by investing in real estate is quite understandable. For most Americans it is the only remaining tax shelter. But the rules can be complex, and in some cases downright arcane. Your question actually covers at least three -- and probably more -- distinct areas, so consult a good accountant or tax attorney to handle the specifics.

Generally speaking, however, people who make less then $100,000 a year may be able to deduct the full loss on an investment property (up to $25,000) from your ordinary income each year. Earning between $100,000 and $150,000 reduces that deduction at the rate of 50 cents for each dollar of income over $100,000. Those who earn more than $150,000 a year can't claim the loss as a deduction in that tax year.

A second home is another story. If you are thinking about buying a property with two homes on it, renting out one and living in the other, you probably will need to divide the property into a portion that is the investment and one that is your residence. Depending on the circumstances, you should be able to deduct the actual rental expenses and depreciation on the rental portion while deducting only taxes and mortgage interest on the other home.

I haven't heard of a 10-mile rule that applies to rental properties or second homes. But the issue of how much time you must live in the home opens yet another can of worms. Generally speaking, you can rent out your home for as long as two weeks a year without reporting that income or paying taxes on it. In this case, you also can't deduct rental expenses. But if you use it for personal purposes for the greater of more than 14 days or 10% of the total time it is rented out, it is considered your home and you might not be able to take rental deductions.

As I said, the rules are complex. Don't try to make a decision based on this short discussion. The only safe thing to do is to consult with a local tax expert who can look at your specific financial situation and real-estate desires to come up with a good tax-saving plan for you.

-- Mr. Irwin has more than 25 years' experience as a Los Angeles-area real-estate broker. He is the author of more than two dozen books about real estate and is recognized as one of the most knowledgeable writers in the real-estate field. Mr. Irwin's most recent book is "Tips and Traps When Renovating Your Home," (McGraw-Hill, 2000).

Submit your question to realestatejournal@wsj.com, with your first name and the city where you're located, which are required to publish your question. If your question is answered and posted, we will show your first name and city.

Although we can't acknowledge all e-mail, we'll answer as many questions as possible.

Email your comments to rjeditor@dowjones.com.