Investment Real Estate – A Great Tax Shelter
I’ve found that most people really don’t understand that tax sheltering benefits of real estate investments.Your investment property can actually shelter its own income and sometimes income from other investments.>How can that be?
When it comes time to do your taxes, you have to figure how much rental income you have received and how much tax deductible operating expenses you have paid out (examples are insurance and repairs).You are left with what is known as your Net Operating Income (NOI) on which you are expected to pay taxes.One of the great things about being a real estate investor is that Uncle Sam has written the tax codes in your favor, he allows multiple deductions on your investment, so you can save money; he does that because he wants to spur on the economy.
One of these deductions is for mortgage interest.Mortgage interest on your investment property is considered an operating expense and the IRS allows you to deduct it.
Another deduction is cost recovery (official name), but is widely known by real estate investors as depreciation.Most people associate the term depreciation with decling property values, but in this case the term is associated with the tax code.Given enough time you can probably bet your real estate investment will increase in value, but you can also bet that it is in fact “wearing out”, the IRS allows you to take a deduction for this presumed decline in value.(This concept combined with a 1031 exchange is a very powerful wealth building technique)
The deprecation deduction is the most exciting part of the tax code.Out of all the deductions involved in your investment this is the only one that doesn’t require you to have written a check thus it does not affect your cash flow ( it is not an operating expense).This powerful deduction can shield most, if not all of your investment’s year to year income from being taxed.Sometimes this deduction can be so large it can cover all of your investment’s income and then in turn provide tax shelter for other real estate investments as well.(We are seeing this with our GO Zone investors)
Here is a simple formula to help you figure this out.
Rental Income less Operating Expenses = Net Operating Income
then
Net Operating Income less Mortgage Interest less Depreciation = Taxable Income
Let’s look at example of how a real estate investor can realize the tax sheltering benefits of real estate investing.
Let’s say you invested in a fourplex that had a rental income of $128,000 and operating expenses of $46,000
Rental Income = $128,000 less Operating Expenses of $46,000 = Net Operating Income of $82,000
Your mortgage intrest for the year was $64,000 and your deprecation deduction was $16,000.
Net Operating Income $82,000 less Mortgage Interest of $64,000 less Depreciation of $16,000 = $2,000 in Taxable Income
Wow! Only $2,000 in taxable income! As you can see, other investment vehicles just can’t compare with the power of properly chosen real estate investments.
Real Estate Investing: The Personal and Financial Benefits
Despite the troubling headlines in the financial pages lately, today’s real estate market can be a very hospitable one for investors. High rates of foreclosures and homeowners selling under financial duress have led to rising home inventories. Combined with the recent decline in home prices in many areas, these factors have helped to create an environment of great profit potential for the savvy real estate investor.
A traditional form of real estate investment is to purchase a home and hold it until the value rises, then sell it for a profit. These days, with so many bargains homes on the market, the patient investor has the potential to realize a much larger profit margin should the property bought in today’s struggling economic climate be held until values rise to a more typical level (assuming the market you buy in has “over-corrected”). People always need a place to live no matter how the markets flow, and properties held in this manner can bring income as rentals until the time is right for selling.
Among the most popular routes to profit in real estate investment in recent years is home “flipping”, where investors buy a home, rehab it, and sell it for a profit. While this may be a bit more difficult in the current real estate market, an investor can realize a substantial profit margin with the many low cost homes available on the market today. While homes may move more slowly than at the height of the housing boom, again, housing is a commodity that is always needed, so patience can bring profit.
Another one of the many benefits of real estate investment lies in the tax advantages that can come with such ventures. Deductions for depreciation of your investment property can be quite lucrative. Since the IRS requires that investment properties be devalued on paper by a standard formula, depreciation can also reduce the amount of capital gains tax you will be obligated to pay when the property is resold at a profit.
There are also tax benefits for investors who are eligible to be designated as real estate professionals. To qualify for these tax advantages, one must spend at least 750 hours managing real estate investments per year, or more than half of total annual working hours. If you meet these requirements, your real estate investing venture can become eligible to claim a long list of business related income tax deductions.
Aside from profit and tax advantages, real estate investing offers more freedom than the typical nine to five job. Residual income from rental properties can offer much in the way of financial security and quality of life by allowing one to work fewer hours for as much income or even more than that steady office job offers.
As with any form of self-employment, hard work and self discipline are required for success. However, those willing to spend some time educating themselves in the basics of real estate investing can find a great deal of satisfaction in controlling their own destiny while enjoying the many benefits of investing in real estate.