Legal And Financial Questions: What Is A Real Estate Tax Shelter?

All real estate has some tax-sheltering benefits. Find the answers to your legal and financial question in his helpful guide.

With all the interest today in owning property it's no wonder people have questions about real estate's reputed tax-sheltering characteristics. What about real estate makes it so beneficial to own?

Conventional wisdom suggests that real estate is valued and valuable because, "˜They're not making any more of it'. While this maxim may be theoretically true, at least as far as land goes, it gets us no closer to the reason for real estate's appeal. Outside of property's intrinsic charm - it can be seen, touched and otherwise provides utility - the reason so many people avail themselves of property ownership is because of its unique value proposition. There is nothing quite like real estate in terms of its accessibility and tax benefits. Anyone who has ever owned a home has enjoyed some of these benefits. And though all real property provides its owner some form of tax shelter, not all types of property or forms of ownership have been created equal.

There are many different ways to own real estate today. Some common ways are through Real Estate Investment Trusts (REITs), Limited Partnerships and direct ownership. The former two examples are "indirect" kinds of approaches in that they do not require the owner to dirty his hands. While REITs and Limited Partnerships still offer some tax advantages over alternative investments, and certainly require less in the way of maintenance than does direct ownership, many of their tax-sheltering attributes, largely because of changes in the law, have been stripped away.

The form of real estate ownership offering the most potential advantage to today's investor is direct ownership. The reason is simple. Under the belief that individual property ownership is good for society, Uncle Sam has put into place a great number of incentives encouraging people to own real estate; the government does not want to be in the business of providing people with housing. Resultantly, home ownership has become synonymous with "˜the American Dream'. Yet home ownership is merely the tip of the iceberg in what is possible for the real estate investor.

Currently, the tax code provides for something called a home-sale tax-exemption. It means that when a person sells his home, having lived there at least two of the last five years, he is exempted from paying taxes on any increase in its value. In other words, the gains are tax-free, and he can do whatever he desires with the proceeds. This is true up to $250,000 in gain; $500,000 in gain for a qualified married couple (irrespective of which spouse might own the property). For further information consult Internal Revenue Code 121.

The home-sale tax-exemption is a pretty nice deal, but it is not the best tax-saving aspect of home ownership. The most significant tax-sheltering attribute of home ownership is the mortgage interest deduction. The mortgage interest deduction, unlike the home-sale tax-exemption mentioned above, provides tax relief today; and unlike with rent, the majority of a person's mortgage payment, typically well over 80% in the earlier years of the mortgage, is tax deductible. Suffice it to say, this has a big impact on the amount of taxes one owes Uncle Sam come April 15th. All other things being equal tax-wise, it likely means you can afford that new item you've had your eye on.

Home ownership is, generally speaking, a good deal. Anyone who is able should consider availing herself of the opportunity to purchase her own home. But the serious real estate investor, the one who really wants to take advantage of real estate's tax-sheltering capabilities, will not be satisfied to simply own her own home.

Conventional folklore suggests when it comes to saving money on taxes and building wealth, more millionaires have been made in real estate than by any other means. There are, in fact, many tax-sheltering facets shared by all forms of real estate. Take for instance the tax-deferral of gains. A person does not pay income taxes year over year on the increase in value of his parcel. He pays taxes only when he sells, and sometimes - think home-sale tax-exemption - not even then. But some types of property inherently offer still bigger potential tax advantages. I am speaking now of rental property. When a person purchases a rental property, he is in fact purchasing a business. Fortunately, unlike most businesses, rental property has the potential after a short while to begin operating smoothly, without one's constant attention. No doubt, there are additional concerns as well as benefits commensurate with owning rental property.

Real estate becomes a business when one begins having tenants. At that point the property owner starts taking in revenue (rental income) as well as paying out expenses. Business expenses are by nature tax deductible. In addition to mortgage interest and property tax deductions, the owner of a tenant property enjoys the ability to write-off (deduct) maintenance expenses. All of these items serve to decrease the taxability of the rental income received.

There is another extremely important factor appertaining to "˜business' property, which is the phenomenon of depreciation. Business assets are said to depreciate, or lose their usefulness, over a certain number of years dependant upon the type of asset (this is so even though the asset may by far outlast its useful life.) To promote and cultivate the health of American business, Uncle Sam has devised a way for the businessperson to more expeditiously "˜recover' some of the cost of business property through an invention known as "˜depreciation'. Depreciation serves to reduce the ultimate amount in taxes a businessperson pays at year's end. In the case of real estate, buildings are depreciable but land is not, and if the property should be sold, the amount depreciated is subtracted from the basis (cost) of the property for purposes of determining tax. The upshot is that a person will have less in taxes now and a little more tax due upon dissolution (sale) of the asset. Depreciation, in other words, is kind of like another form of tax-deferral. It's better to pay later than now.

With real estate, depending on the amount of income, expenses, and depreciation, it is actually possible to make a profit and show (for tax purposes) a loss. This means a person could have "˜positive cash flow' and legitimately file a loss on her property. That's not even the best part. This loss can then be used to reduce the amount of taxes otherwise owed from her "real" job (to the extent the passive loss rules allow), thus increasing the amount of money in her pocket even further! This is what she calls her real estate tax shelter.

One more important reason why real estate may be the best business going. Leverage. Everyone's heard of it, but what does it mean? Leverage has to do with debt, and debt is something most people feel they could do without. Like cholesterol, there is good and bad debt. The key to sound financial health is increasing the good debt and decreasing the bad. Let's look at this.

Everyone would like to have a big income. Furthermore, everyone would like to have a big income without particularly having to do a lot to earn it. Leverage allows a person not to have to work so hard to earn it. Consider, say you have $10,000. Let's assume, through shrewd investment, you are able to earn 10% per annum on your $10,000 investment. That's $1,000 a year in income. What if you had the opportunity to borrow an additional $10,000 at a cost of 5%? That's $500 a year in interest expense. And what if you turned around and invested the additional $10,000 alongside the original? Now you would be making $2,000 per year in revenue with $500 in expense for a net total of $1,500 per year in revenue. For each incremental borrowing of $10,000 at 5%, and subsequent investment at 10%, you would be netting an additional $500 per year. Now wouldn't you want to replicate that scenario as many times as possible, infinitely if you could? That's utilizing debt wisely, and that's good. That's leverage.

With real estate, the average investor has an opportunity to leverage his original investment of $10,000 many more times than in most other businesses. Why is that? Because banks happen to like real estate, it provides them with good collateral. And the more you borrow, the better banks seem to like you, the easier it is to get another loan, and the bigger your portfolio grows.

Aside from residential real estate there is also commercial: warehouses, strip malls, and the like. Generally, banks are not as willing to lend when it comes to these types of commercial properties and to the larger multi-unit rental properties. They require more collateral (down payment), which affords the prospective owner less leverage. While commercial property does offer some advantages such as less management responsibility, many people may find a small multi-unit property a better place to start.

In real estate, as with any business proposition, it's best to do the homework yourself. Know the market, check with reliable sources, crunch the numbers, and by all means hire an attorney to facilitate when you find yourself confronted with confusing contracts. If you do your homework and use common sense, there's a good chance you'll make that real estate tax shelter work for you.

© High Speed Ventures 2011