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
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.