Purposeful Planning And Tax Shelter For Real Estate Investing

Posted @ 9:27 pm - Filed under 1031 Exchanges, Real Estate Investing, Purposeful Planning, Retirement, Cash Flow, Retirement Income, Investment Lessons, Depreciation, Tax Shelter

Caveat: There’s an old saying that says you shouldn’t buy real estate solely for the tax shelter. I’ve seen some exceptions to that rule. But just a handful, and they tended to prove the rule, not otherwise. Yer gonna get some tax shelter whether you want it or not. Of course, if you don’t want yours, we can talk.

Let’s all get on the same page first. What is tax shelter in real estate terms? Simply put, depreciation is the loss of value of your building. Land isn’t depreciated because it doesn’t wear out. Even better, depreciation shows up on your tax return as a loss — one you didn’t feel, ‘cuz it’s also known as a ‘phantom loss’. Make sense? You didn’t really lose any money — it’s a paper loss only. Yet you get to claim you lost money.

How cool is that? You mean you never got the memo?

This loss saves you money through income taxes you now don’t have to pay. Those are real dollars, and the taxes you aren’t paying are real return. Said another way — these are dollars that but for the depreciation would be leaving your Levi’s and heading towards the IRS. A quick example would be an investor with a $90,000 income from their day job. By the way, yer ‘day job’ pay is called ordinary income. (Don’t take it personally.) The maximum depreciation allowed to apply to your ordinary income is $25,000/yr., which means you now earned $65,000 instead of $90,000. Pretty cool, eh? And that’s before you even begin to take the deductions for your kids, house interest, etc.

There’s a catch though for folks making ordinary income of six figures, especially once you pass $150,000 a year. It’s at that point yer no longer allowed to apply your depreciation to ordinary income. At $100,000 they start reducing how much you’re allowed, until you hit the $150,000 mark. Go figure. This isn’t all bad. Stick with me.

Let’s say you buy property(s) throwing off $50,000 annual depreciation, but your income level bars you from using it. If your properties are basically break even cash flow, that depreciation remains virtually unused. If you hold these properties say, five years, that’s $250,000 unused tax shelter. Let’s back up a minute. Regardless of your ordinary income level, your depreciation is always allowed to shelter the income (cash flow) coming from your properties. It’s only ordinary income the IRS covets so dearly — at least so far.

So back to five years of unused depreciation, and wanting to execute a tax deferred exchange. Here’s something very cool, and yet known by few investors. To mix metaphors, you can be partially pregnant — there’s such an animal as a partial (1031) tax deferred exchange. You can now trot out all that unused depreciation and apply it to some of the capital gain inside your exchange. Without confusing things here, suffice to say you’ll still end up with the same new properties, just with a lot more new depreciation than you would have. This is ‘cuz the money you pulled out of the tax deferred exchange wasn’t taxed due to the offset ‘loss’ of the unused depreciation.

This then results, ironically, in the investor — that’d be you — ending up with more future depreciation (read: tax shelter) than you would have with a 100% tax deferred exchange. Your Purposeful Plan will sometimes incorporate this option several times as you journey towards your retirement party. Imagine arriving at your retirement with an aircraft carrier full of unused depreciation ready to shelter your magnificently abundant retirement income — there are worse thoughts to have. How’d you like to pull out several hundred grand of cash without capital gains tax grabbing it’s Fed/State share?

Works for me — work for you too?

It’s just one factor in an all inclusive Purposeful Plan made with only your future in mind. For many of you this has answered a few questions you didn’t know to ask. Ever wonder how many other questions like that there might be? Please don’t hesitate to Contact BawldGuy and set up a phone conference. If you live in San Diego, we can actually meet in person, which is even more fun.

This entry was posted on Wednesday, May 7th, 2008 at 9:27 pm and is filed under 1031 Exchanges, Real Estate Investing, Purposeful Planning, Retirement, Cash Flow, Retirement Income, Investment Lessons, Depreciation, Tax Shelter. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.