Real estate investments are a smart way to build wealth. However, it also counts as “taxable income,” opening the doors to higher tax rates.
That’s why today, we’ll be focusing on tax shelters.
Paying capital gains tax can extract a lot of money out of your wallet if you don’t inquire about all the options you have. The real skill is knowing how to deal with these expenses and using the possible tax deductions to your advantage.
Bear with us because we will be taking you through a complete guide on using real estate as your own tax shelter and lowering your expenses.
Don’t worry if you’re new to all this. We’ll be explaining tax shelters, long-term capital gains, and real estate investing basics in this guide!
Introduction to Tax Shelters: What Are They?
To begin with, what are tax shelters?
In simple terms, a tax shelter is a means for real estate investors and property owners to store assets so that their current and future tax rates are minimized to the fullest. Tax shelters vary in terms of real estate investments or investment accounts to transactions that lower the income tax rate.
Essentially, your income tax rate is lowered with the help of various deductions and credits.
Investing in real property is a widespread tax shelter. Some of the benefits include lowering mortgage interests, recovering the costs of an income-producing property via depreciation, borrowing against real estate equity, and using 1031 exchanges to defer profits from investing in real estate – but we’ll get back to that in more detail later.
Besides real estate investment, common tax shelters include:
- Pension funds and plans
- 401 (k) and 403 (b) plans
- IRAs – Individual Retirement Account
- Starting up your own business
- Municipal bonds
Legitimate Vs. Abusive Tax Shelters: Be Aware of the Difference
The difference that sets apart legitimate and abusive tax shelters is the final result – the tax benefits.
Abusive tax shelters do not help you reduce your expenses – they merely help you avoid your obligations, which is illegal, of course.
What this system does is considerably lower the amount of money and defer taxes that a taxpayer owes to the government. Additionally, it won’t provide the taxpayer with any means of gaining money.
People who rely on abusive tax shelters do it for the purpose of hiding money that they keep in their piggy bank – in literal terms! Abusive tax shelters are commonly known as “multi-layer transactions” because they disguise the owner by letting the money flow through multiple entities.
Makes you think of money laundering, right? Well, we don’t have to tell you that you can be prosecuted for this – so, be careful!
Tax Shelter: Note-Worthy Terms
If you’re new to real estate and tax shelters, here’s a short glossary of terms that you should know:
- A tax strategy is a plan that consists of supporting facts that work towards a tax deduction.
- A tax code is a code that your employer or provider uses to work out exactly how much tax income you have to pay. Similarly, the IRS tax code refers to Internal Revenue Code – a collection of tax laws legislated by federal law and local authorities.
- Short and long-term capital gains represent the evident increase in your capital asset’s value. Short-term capital gains refer to when you sell an investment property that’s been in your possession for less than a year. Contrary to that, long-term capital gains refer to a rental property that’s been held for over a year.
- A depreciation expense is the amount of money that can be deducted from your gross profit in order to lower your tax bill.
- A tax advisor is a licensed individual, a financial professional who helps you develop a tax strategy that’ll reduce your tax fees and enable you to stay within the limits of the law.
- A tax season traditionally occupies the time between January 1st and April 15th, when taxpayers prepare their financial statements and calculate their total taxable income.
How Real Estate Investors Lower Tax Bills?
It’s time to get to the heart of the matter and discuss how real estate investors can use their properties as tax shelters. Of course, not all of these will work for you – it all depends on your current situation. Still, you can use these to your advantage and get tax relief and incentives.
Annual Tax Deduction (Depreciation)
An annual tax deduction, called depreciation, allows you to recover the cost of your income-producing rental property. In essence, it accounts for the wear and tear that your rental property goes through in its lifetime, serving as a reasonable allowance for deterioration and obsolescence.
Taxpayers who are already familiar with this depreciation method can use it to their advantage and pay capital gains tax rates that are much lower than the amount they would’ve originally paid.
MACRS (Modified Accelerated Cost Recovery System) is the common choice for real estate investors, primarily because with this tax deduction, residential property is depreciated over 27.5 years, while appliances and fixtures are depreciated over 15.
It’s important for you to remember that different states have different tax codes – and therefore, their capital gains tax deductions may vary.
What Is Bonus Depreciation?
Bonus depreciation is a tax benefit that gives you the opportunity to deduct a large percentage of the eligible asset’s purchase price rather than writing them off over time.
Let’s bring this closer by using an example:
When a rental business acquires machinery, the total cost is spread over the “useful life” of a particular asset. The rules have changed, and now, the bonus depreciation deduction for qualified properties has doubled (from 50% to 100%) and applies to properties that were acquired and placed into service after December 2017.
1031 Exchange
Another thing a real estate investor could do is take advantage of the 1031 exchange section within the Internal Revenue Service code. It’s one of the most common tax strategies because it allows taxpayers to defer their capital gains tax by making a real estate sale and then using the equity to buy another – invest in real estate of equal or greater value again.
However, since 2017 it only applies to exchanges of real estate property held for use in business or investment, other than properties held mainly for sale.
If you’re interested in this particular tax strategy, you should know that the following criteria must be met:
- The total value of the replacement property must be equal to or greater than the purchase price.
- It must be a real estate investment – a like-kind exchange.
- Both properties must have a productive or work-related purpose.
A property that’s been received through a transaction that doesn’t meet “like-kind” criteria will not be accepted, though, and will be subject to capital gains tax.
Entering Into 1031 Exchange Agreement – A Quick Guide
- Rental property owners must enter into a 1031 exchange with an intermediary qualified to put the rental property up for sale. Meanwhile, the investor should start the search for a replacement rental real estate.
- On the day of the sale, all expenses are sent to the account set up by the intermediary.
- The investor has to enter into an identification period and has a 45-day limit to set up a list of qualified replacements.
- By using the proceeds from the sale, the investor is able to close the deal on the new investment.
- The intermediary should transfer the funds to the title company, completing the transaction.
Borrowing Against Home Equity
A real estate professional that was able to build up sizeable equity in either the investment or personal property has the opportunity to refinance their real estate properties and pull out equity that can help in further real estate investing.
Here, regulations vary according to state. Moreover, it depends on your credit score, debt-to-equity ratio, and debt-to-income ratio.
Deferring Taxes on Home Sales
The gains from the home sale of the taxpayer’s personal residence don’t fall under the category of capital gains taxes. The limit for exclusion for married couples that file jointly is $500,000. As for single individuals, it’s $250,000.
In the event that the capital gain of the taxpayer is greater than the exclusion, they can invest in a 1031 exchange as a way to lower their capital gains tax.
Since there are many investors that live in areas in which house prices are constantly rising, it would be wise to rely on the strategy of trading up to minimize real estate taxes and attain a huge benefit in terms of personal wealth.
Deducting Your Mortgage Interest
Homeowners can deduct a small portion of their mortgages that can be attributed to interest payments on their tax returns. Keep in mind that the interest paid is higher during the early years of the mortgage, gradually decreasing as time passes.
According to the Internal Revenue Service (IRS), a homeowner can deduct the mortgage interest in the first $750,000 of indebtedness. However, if deducting mortgage interest from the indebtedness incurred prior to December 2017, higher limitations of $1 million apply.
Home Office Deduction: Who Qualifies?
If you’re working from home as a small business owner, you can save a lot of money by taking advantage of the so-called home office deduction. As long as you meet the requirements and keep track of your records, this could potentially be a great tax shelter.
Basically, if you use a section of your home for business-related purposes, the IRS lets you write off a portion of your expenses – such as rent and repairs, for example.
Here’s something to remember about this type of deduction:
Even if the room intended for business purposes is not the only place you meet with your clients, it must be the primary one. Otherwise, the deductions could be removed – and you could lose your tax savings.
On a related note, if you’re the sole owner and employer in your company, expect the self-employment tax rate of 15.3% of net earnings. However, the benefit of investing in rental properties is that your real estate gains don’t count as “earned income,” meaning they’re not subject to the self-employment tax rate.
Is Anything Tax-Free?
Yes, there are entities that are tax-free – and we’ll take this opportunity to mention the most notable groups.
Non-Profit Organizations
Organizations that make no profit are exempt from paying tax. Eligible organizations are mainly located in the public sector – schools, hospitals, churches, and the like.
U.S. Citizens Working Abroad
If you’re a legal citizen of the U.S. but work overseas, there is a possibility that you will be exempt from paying taxes. However, the taxpayer must meet specific conditions for this.
Low-Income Taxpayers
Not everyone earns the same amount; that’s a given. If you belong to a low-income group whose profit does not reach the standard deduction – you are exempt from taxation. You don’t even have to file it.
While these groups are exempt from taxes, members of the military may qualify for special tax treatment. With the help of this benefit, members do not have to pay taxes on certain types of income –passive income from real estate, for example.
Final Thoughts
We’ve successfully walked you through the topic of using your real estate investment property as a tax shelter. You had the opportunity to pick up a few strategies on how to minimize your taxes from rental income.
Investors can lower their capital gains taxes with an annual tax deduction strategy, borrowing against home equity, deducting mortgage interests, relying on 1031 exchange, and deferring taxes from home sales.
And if you served in the military, there’s a good chance you qualify for special tax treatments that frees you from paying certain types of tax.
Some individuals and organizations are tax-free, though – including schools, churches, and hospitals. They’re completely exempt from paying tax and don’t even need to qualify.
Whatever option you decide to go with, you must meet the requirements within the IRS. In a nutshell, there are ways to minimize your capital gains tax obligations by staying on the “right side” of the law.
If you’re having trouble navigating the housing market, sign up for our free trial at Mashvisor – and allow us to help you in your search for the perfect investment property!