Real Estate Tax Shelters: Types, Opportunities, Pros, Cons

|

Jun 6, 2023

Trustworthy is an intelligent digital vault that protects and optimizes your family's information so that you can save time, money, and enjoy peace of mind. Learn more from our webinar recording.

1040 document and cash on a table

Real Estate Tax Shelters: Types, Opportunities, Pros, Cons

|

Jun 6, 2023

Trustworthy is an intelligent digital vault that protects and optimizes your family's information so that you can save time, money, and enjoy peace of mind. Learn more from our webinar recording.

Real Estate Tax Shelters: Types, Opportunities, Pros, Cons

|

Jun 6, 2023

Trustworthy is an intelligent digital vault that protects and optimizes your family's information so that you can save time, money, and enjoy peace of mind. Learn more from our webinar recording.

1040 document and cash on a table

Real Estate Tax Shelters: Types, Opportunities, Pros, Cons

|

Jun 6, 2023

Trustworthy is an intelligent digital vault that protects and optimizes your family's information so that you can save time, money, and enjoy peace of mind. Learn more from our webinar recording.

1040 document and cash on a table

The intelligent digital vault for families

Trustworthy protects and optimizes important family information so you can save time, money, and enjoy peace of mind

The intelligent digital vault for families

Trustworthy protects and optimizes important family information so you can save time, money, and enjoy peace of mind

If you’re looking for a way to invest your cash for the future, the chances are that real estate has already crossed your mind — and with good reason.

There are almost 20 million rental properties in the US, and the average three-year return on a property is currently sitting at 4.73%.

That alone makes real estate an attractive investment opportunity. But if you add in the potential tax benefits, real estate starts to look even better.

Investment properties are often considered a type of tax shelter because the IRS lets you deduct such a wide range of expenses from your tax bill. You’ve just got to make sure you understand the law and take on professional advice before investing.

To help you decide whether real estate tax shelters are the right option for you, we’ve created this guide that walks you through the different types of real estate tax shelters, the pros and cons of investing in property, and more.

Key Takeaways

  • Real estate tax shelters enable you to reduce your tax bill through deductions and capital appreciation.

  • Types of real estate tax shelters worth exploring include real estate investment trusts (REITs), 1031 exchanges, depreciation, and mortgage interest payments.

  • Rental income is still taxable even if your investment property is mortgaged.

Is Real Estate a Good Tax Shelter?

Calculator, pencil, paperwork and mini house on a table

The short answer is: Yes, real estate can be an effective tax shelter. It’s a particularly strong wealth management strategy for high-net-worth individuals looking to simultaneously invest for the future and slash tax liabilities.

Real estate can be an effective tax shelter due to its potential for capital appreciation and various deductions. For example, deductions for mortgage interest and property taxes can offset taxable income, resulting in lower overall tax liabilities,” says Joseph Melara, Managing Broker at Residential Brokers

“I have seen numerous clients benefit from these deductions, which contribute to their long-term financial goals.”

Because real estate is an asset that tends to rise in market value, it’s considered a fairly evergreen investment opportunity. In the domestic real estate space alone, house prices have risen an average of 5.4% every year since 1992.

Meanwhile, the IRS allows for a range of deductions and tax credits in real estate that can save you a decent chunk of change.

If you get the balance just right, that’s a proverbial win-win. But the truth is that there are a range of real estate tax shelter opportunities — and each type goes hand-in-hand with its own unique set of pros and cons.

What is a Tax Shelter?

Before we speed right into the different types of real estate tax shelters, it’s worth pumping the brakes and talking about what a tax shelter actually is.

A tax shelter is an investment or transaction that you make with the intention of lowering the amount of income tax you owe to the IRS.

One of the most common tax shelters in the US is a real estate investment property, but individuals will also often utilize investment accounts or borrowing to limit their tax liabilities. For example, you can shelter yourself from taxes by borrowing against equity, setting up a 401(k) plan, or deducting property management fees you have to pay.

But as we’ve already touched upon, real estate is widely considered one of the more attractive tax shelter options because demand for property is constant. As a result, hedging your investment portfolio by investing in real estate is a smart way to build wealth for the future.

What Are the Pros and Cons of Real Estate Tax Shelters?

Just like any other type of investment opportunity, real estate tax shelters aren’t for everyone. They have a unique set of advantages and disadvantages you should be aware of before you take the leap.

We’ve already talked about the basic tax advantages you can expect to leverage through real estate. But other benefits include the fact that you’re generating regular rental income. This passive income stream is a great way to build your wealth at a steady rate over a prolonged period.

In terms of disadvantages, it’s important to bear in mind that real estate isn’t a sure thing. Although property prices do tend to go up like clockwork, market fluctuations can create an element of risk.

A lot of the deductions that make real estate a type of tax shelter can be a little bit complicated, too. There are specific requirements you need to meet, so you’ll normally need to get help from a tax advisor or an accountant to make sure you’re abiding by IRS rules.

“My advice to individuals considering utilizing real estate as a tax shelter is to do their research and consult with a financial professional,” warns Eric Lee of REIInsiders.com.

“Real estate can be a great investment, but it is important to understand all the potential tax implications and take steps to minimize those taxes. It is also important to carefully consider the potential risks associated with real estate investments.”

What Are the Different Types of Real Estate Tax Shelters?

Professional with a calculator sitting across the table from a couple

There are a number of different types of real estate tax shelters. Some of the most flexible and dynamic real estate tax shelters include real estate investment trusts (REITs), 1031 exchanges, depreciation, and mortgages.

It’s worth pointing out these are just the tip of the iceberg. There are plenty more real estate tax shelter opportunities that might be available to you — but they do tend to get quite complicated fast. That’s why we’re focusing on the most tried-and-tested real estate tax shelters.

Real Estate Investment Trust

A real estate investment trust (REIT) is an investment fund that buys, sells, and holds properties with the goal of generating returns for investors. You can buy shares in a REIT, and you’ll then normally get income from the REIT in the form of dividends.

“REITs are a great way to invest in a variety of real estate projects without having to manage the properties yourself,” says Eric Lee, Co-Founder at REIInsiders.com.

“REITs have the potential to provide investors with a steady income stream, as well as the potential for capital appreciation.”

Legally speaking, REITs are required to distribute 90% of their taxable income back to shareholders. 

Most REIT dividends come from operating profit — and because shareholders get this in the form of dividends, that profit gets taxed as nonqualified dividends at each investor’s marginal income tax rate.

Investment portfolios range from everything to commercial property and private housing to corporate office space, warehousing, public-private partnerships (PPPs), and everything in between.

Real estate investment trusts can be a great investment in that they are typically not correlated to the stock and bond markets. So when the stock markets and/or bond markets go down (like they did last year), these investments do not necessarily follow suit,” explains Eric Mangold, a Wealth Manager at Argosy Wealth Management.

“Many of these REIT funds also have good growth track records too, so you are not sacrificing growth to invest in these funds.”

Investors don’t have to pay corporate income taxes on REIT profits, and return of capital distributions are all tax-deferred. Better yet, REIT shareholders are allowed to write off 20% of their annual dividends under the IRS-qualified business income deduction.

1031 Exchange

Another popular real estate tax shelter is a 1031 exchange. This is a transaction in which you trade an investment property for another property — which is why people also sometimes call a 1031 exchange a “like-kind exchange”.

When you use a 1031 exchange, the IRS will let you defer tax on any capital gains you’ve made from the property until you sell your new replacement property.

“The benefits of this tax-deferred exchange are simply too great to ignore. With a 1031 exchange, individuals can defer paying taxes on the sale of their property by reinvesting the proceeds into a similar property,” says Leighanne Everhart, owner of Sell My House Fast Wilmington NC.

“This allows them to continue growing their investments without the burden of hefty taxes. Additionally, the opportunity for diversification and increased cash flow makes utilizing a 1031 exchange a no-brainer in my opinion.”

That being said, it’s important to note the IRS does impose a few strict rules around the use of a 1031 exchange.

First and foremost, properties must be of a like-kind. In the eyes of the IRS, that means “they’re of the same nature or character”. But it’s okay if the two properties differ in grade or quality.

For example, you can flip a 5-bedroom house that you’ve totally remodeled and then claim a 1031 by investing in a 4-bedroom house that needs totally gutted and redone from scratch.

But you couldn’t sell a condominium and then turn around and buy retail space downtown, because those aren’t properties of the same nature.

There are a couple of other basic rules, too.

You can’t claim a 1031 if you’re buying a home for yourself or your loved ones. It needs to be an investment property only. In addition, the value of your new property needs to be the same or greater than the value of your previous investment property.

This is all time-stamped. You need to buy your new property within 180 days of closing on your previous investment property to qualify — and you’re supposed to create a shortlist of three potential investment opportunities within 45 days of closing on the sale of your original investment.

Depreciation

Most investors are familiar with the concept of depreciation. This is when an asset decreases in value over time due to waning output (or, in the case of real estate, wear and tear).

But in the context of real estate investments, depreciation is also a common method that individuals use to lower their tax liabilities.

“Depreciation allows investors to write off a portion of the cost of the property as a business expense, which can help to reduce the amount of taxes owed,” says Eric Lee of REIInsiders.com.

If you want to reduce your overall tax obligations using depreciation, you can deduct the cost of property repairs and other improvements as necessary expenses.

According to Leighanne Everhart of Sell My House Fast Wilmington NC, there are two ways investors can achieve this: by using straight-line depreciation or accelerated depreciation.

Straight-line depreciation allows me to deduct a portion of the cost of the asset each year, which ultimately reduces my taxable income,” she says.

“On the other hand, accelerated depreciation allows me to deduct a larger portion of the asset's cost in the early years of ownership. This method can be particularly helpful when I need to offset substantial profits.”

Depreciation deductions are normally spread over the lifetime of an asset — which means you’re not going to be able to write off your entire tax bill on an annual basis. Instead, you’re looking at a relatively small number of deductions spread over the course of 15 to 20 years.

But it’s a reliable and simple way to keep your tax bill down.

Mortgage Interest

Finally, you’ve got mortgage interest. If you’re carrying a mortgage on a property, you’re going to pay interest on that loan throughout the year. That interest can then be deducted from your annual tax bill.

“Mortgage interest deduction is one of the most well-known tax benefits for homeowners,” explains financial coach Michael Ryan.

“By deducting the interest paid on a mortgage, taxpayers can potentially lower their taxable income. This deduction can be particularly beneficial for individuals with high mortgage interest payments.”

Just like depreciation and 1031s, the IRS does impose a couple of important rules around mortgage interest deductions.

First off, you can’t claim a deduction on home equity loan interest. Any time you take out a secured loan against equity you already have in your property, the interest on that loan is non-deductible.

Next, there’s a limit to how much you can claim as a deductible. You’re only allowed to deduct the first $375,000 worth of mortgage interest payments if you’re filing solo. If you jointly file with your partner, you can claim a combined $750,000 in interest payments.

Because of these rules, experts generally recommend you seek professional advice to make sure you’re claiming interest deductions correctly.

“This is a great way to save money and maximize your tax benefits. However, it's

important to note that there are restrictions and limitations on how much mortgage interest you can deduct,” says Sell My House Fast Wilmington NC’s Leighanne Everhart.

“In order to fully take advantage of this deduction, it's important to consult with a tax professional and stay up to date on the latest tax laws and regulations.”

Staying Organized With Trustworthy

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Any investment opportunity has a number of risks and liabilities, and real estate tax shelters are no different.

If you’re considering investing in real estate, you should be aware of the laws and tax rules both locally and federally around real estate income. 

To stay on top of it all, you’ve got to make sure you’re keeping track of operating costs, rental income, and any other expenses you might be able to use to offset your income tax bill.

That's where Trustworthy can really support you.

Trustworthy is the only platform out there that gives you a centralized view of all your family’s essential information. If you’ve invested in property, that means our digital safe securely stores your estate documents, tax records, insurance information, property invoices, income records, and everything else you could possibly think of.

Long story, short: With Trustworthy, you and your financial planner will always be organized and up-to-date on what’s going on with your properties and your taxable income. Find out how you can get started.

Frequently asked questions

How Can I Avoid Paying Tax on Rental Income?

You probably won’t be able to avoid tax completely. But you can minimize tax payments on rental income by taking advantage of deductions for operating expenses, depreciation, and mortgage interest.

Do I Pay Tax on Rental Income if I Have a Mortgage?

Yes. The IRS always taxes rental income from a property you own as ordinary income. It doesn’t matter whether you have a mortgage on the property or not.

Can You Deduct Mortgage Interest on an Equity Loan?

No. The IRS doesn’t let you deduct mortgage interest payments on home equity loans you’ve taken out to make improvements on an investment property.


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