Sammarusich Blog

These tips on rental property deductions that we’re going to share with you will provide you with an immense tax shelter. You’ll see that there are several tax deductions that you can take by owning even one rental property.

I know this because I’ve owned rental properties for several years and have taken advantage of these tax savings.

Treating Real Estate As An Investment Instead Of A Small Business

You’ll achieve the largest tax savings as a real estate investor; not a small business. Real estate used as a small business includes realtors, builders, contractors and people that buy property to sell it quickly (flip homes). They have a real estate “business” and are not considered investors.

On the other hand, a real estate investor buys a property as a long-term investment, which is greater than 1 year’s time, to rent out to tenants.

Rental Property Deductions

You will take your rental property tax deductions on IRS Schedule E. This schedule is where you’ll indicate your investment property income and expenses. As you can see, there are several expenses that can be taken as deductions, including “other” expenses (line item 18).

Here is a comprehensive checklist of rental property tax deductions that you can take advantage of as an investor:

*Advertising

*Auto

You can deduct any mileage you drove to maintain and manage your property. For instance, you drive from your home based office (which you can set up as a landlord) to your rental property. You would be able to claim this mileage as an expense on your Schedule E.

You may notice the key words being “maintain and manage” your property. This means if you need to drive out to the property to check on how a repair is coming along, you can write off this mileage.

If you drive to your rental home to speak with your tenant about anything regarding the home or to collect rent, this is deductible mileage.

Managing your property can also include doing a drive by to look at the property to ensure it’s in good standing. Just make sure you keep good mileage records including the purpose of the trip.

*Depreciation

Your residential rental property gets depreciated over 27.5 years. For example, if you pay $100,000 for the home, you can take a depreciation tax write-off of $3636 ($100,000/27.5 yrs) per year, which is taken as a “paper loss” against any gross income you make. This is a substantial tax deduction.

* Cleaning & Maintenance

* Homeowners insurance

* Mortgage Interest

* Property taxes

* Utilities (if you pay them instead of the tenant)

* Phone costs, PO Box, internet costs related to your rental property

* Repairs & Supplies

* Educational Expenses

* Real estate club dues

* Tenant credit report fees

* Professional fees

* Management Fees

*Homeowners association fees

There is no dispute that rental properties are one of the few best remaining tax shelters you can take advantage of to achieve big time tax savings.

Tax shelters can be good–reducing your taxable income. But tax shelters can be bad–illegal and causing participants to commit tax fraud. How to know what shelters to avoid? The key is education, read the IRS forms, and pay attention. The old caveat, if it sounds too good, it’s most likely bad, is very often true. The best tax shelter for the business owner is to use sound tax planning strategies and think of your business as a legal way to avoid and rightfully reduce taxes. It is all in the deductions and keeping good records (receipts, checks, daily journals).

A tax shelter is a type of investment that allows people to reduce their tax liability. Pension plans and real estate investments are good examples. Persons can reduce taxable income if you have losses on investments. These are all legal strategies. But fraudulent or “abusive tax shelters” are considered by the IRS to use many schemes to filter or hide transactions: trusts, off-shore credit/debit cards, hedges, circular cash flows, defeasances, insurance schemes, and other activities are all attempts to hide. If investments insulate the client from significant economic risk, the courts have decided they are not appropriate.

The IRS considers tax shelters “abusive” when they are designed solely for avoiding taxes. They have no other significant business purpose. There are various means to do the abusive practices–helping clients falsify tax losses or report phony tax losses. In 2005, KPMG, a Big Four accounting firm, cost the U.S. $2.5 billion, according to the Department of Justice, by helping clients to develop tax losses. The following scenario (from Grace Wong, a reporter from CNN’s website “Money”) is a simplified explanation of one method such firms used to help clients develop tax losses.

Here’s an example:

* Joe is a new millionaire and has capital gains of $20 million. He wants to create an “artificial” loss.

* Joe places an option in identical amounts and prices on the euro /U.S. dollar for exchange rates. He buys a call option with the right to buy Euros at a certain price on or before a certain date for a premium of $20 million. He writes an option with the same strike price and expiration date for $20 million. The premiums offset each other.

* Joe then transfers the option to a partner in a friendly “accommodation” partnership, someone who paid big fees to enter into a partnership with no real business purpose.

* When he sells for zero profit, Joe claims a tax loss of $20 million, even though he’s incurred no real economic loss.

Hard to follow the details? The concepts of many bad tax shelters lack definable business purpose. An “abusive tax shelter” is a marketing scheme that offers tax transactions with little or no economic value. In the real world people invest money to make money. The bad kind of tax shelters offer inflated tax savings based on large tax write offs and tax credits out of proportion to your investment. There is no real economic investment. An abusive tax shelter often involves little risk and its tax write off ratio is frequently much greater than one-to-one. If you use a tax shelter, be sure to file Form 8271 from the IRS. Read the experts. Read the known tax shelter abusers listed on the government’s IRS site. And below are some of the worst schemes for abusive tax shelters.

Tax Shelters the IRS Dislikes
Lease In Lease Out(LILO) Sale In Lease Out (SILO) Partnership Straddle Corporation Owned Life Insurance Sham Transactions (COLI) Overseas Shelters

Tax-Sheltered Annuity (TSA), also known as a 403(b), is an alternative retirement savings plan. Not everyone can participate in this plan, and it is restricted to those who are employed by educational, cultural, or non-profit organizations such as religious groups (also known as 501 (c)(3) organizations).

TAX-SHELTERED ANNUITY BENEFITS

Contributions to a Tax-Sheltered Annuity are done through a payroll deduction and are therefore taken out pre-tax. This feature of a Tax-Sheltered Annuity is very beneficial since your contributions are not seen as income and you may pay less federal tax at the end of the year. A Tax-Sheltered Annuity is also tax deferred during the accumulation phase. This means you will not pay any taxes on the amount you contribute or the interest earned until you begin the withdrawal phase.

If your plan allows, you may elect to contribute post-tax money to your Tax-Sheltered Annuity by using your paycheck. Any money you contribute post-tax must be declared on your income tax return and is not subject to the tax-deferred exemption. When selecting a Tax-Sheltered Annuity you may choose between fixed and variable, or a combination of the two.

It is possible to take loans from your Tax-Sheltered Annuity, but these loans are limited to the lesser of $50,000 or fifty percent of your vested amount. Another feature of a Tax-Sheltered Annuity is the ability to rollover funds into other investment options. For example, it is possible to use your 403(b) to fund your 401(k), Individual Retirement Account (IRA), or another 403(b).

It is important to check any contribution limits or rules established by the new plan administrator before committing to a rollover. If you die before receiving payments, your beneficiaries are entitled to similar options using your Tax-Sheltered Annuity. A spouse is entitled to all of the aforementioned options, while a non-spouse is prohibited from using your annuity money to fund an IRA. A non-spouse beneficiary is only able to transfer funds from one 403(b) to another.

CONTRIBUTION LIMITS OF A TAX-SHELTERED ANNUITY

Unlike a regular deferred annuity, there are maximum contribution limits determined by the Internal Revenue Service (IRS) for each year. Beginning in 2006 the maximum personal (elective) contribution limit was increased to $15,000 per year, up from $14,000 in 2005. Also in 2006, your employer (non-elective) may choose to contribute to your Tax-Sheltered Annuity with a combined maximum contribution limit of $ 44,000.

You may be able to contribute up to $5000 more per year if you are age 50 or older and an additional $3000 per year if you have been with the same company for more than fifteen years. Failure to comply with these contribution limits can result in additional taxes and penalties for both the employee and contributing employer.

TAX PENALTIES OF TAX-SHELTERED ANNUITY AND AGE REGULATIONS

As with the deferred annuity, a Tax-Sheltered Annuity is used to supplement retirement income. If you decide to withdraw money prior to age 59

When my wife and I were shopping for our first home, we faced a common fear that many first time home buyers struggle with. Although the monthly mortgage payments that we were potentially facing were within our means, we were afraid that there would not be any money left over at the end of each month for much else. One of the factors that we had not accounted for in our budgeting, however, was the federal income tax benefits that we would receive as a home owner. Federal income tax benefits are how the United States government helps make owning a home affordable. As a home owner, these benefits are provided to you in the form of income tax deductions that can lower your tax liability and increase your monthly take-home pay. When you own your home, in most cases the IRS allows you to deduct the interest payments that you make on your mortgage and the property taxes you pay on your property from your taxable income.

Before explaining income tax deductions in more detail, I want to first provide an overview of mortgage interest and property taxes. Most of the mortgages available today are amortized in such a way that each of your monthly mortgage payments include a portion that goes towards paying off your loan principal and a portion that goes towards paying interest to the bank. In the case of tax deductions, only the portion of your mortgage payment that gets applied to interest is what is considered. You can use a mortgage calculator to help understand how your monthly mortgage payment gets split between principal and interest. Property taxes, on the other hand, are annual taxes that you pay to your county. In many cases, your entire property tax payment can be counted as a tax deduction.

The mortgage interest and property tax deductions that the IRS allows can make a significant positive impact on how much federal tax you pay each year. As an example, assume that last year you earned $100,000 in income and were in the 21% federal tax bracket. If you did not have any deductions, last year you would have paid $21,000 in federal taxes. Now, assume that you bought a home this year on which you pay $25,000 each year in mortgage interest and $5,000 in property taxes. As a home owner, the federal tax benefits that are available to you allow you to deduct these payments from your $100,000 income. This deduction reduces your federal taxable income to $70,000 and lowers your federal tax bracket to 17%. By reducing your federal taxable income to $70,000 and your federal tax bracket to 17%, your federal tax payment this year will be $13,000, an $8,000 savings over the $21,000 you paid last year.

You do not have to wait until the end of the year, when you file your tax returns, to get the benefit of your home ownership tax deductions. By using a mortgage calculator to project how much you will pay per year in mortgage interest and property taxes, you can adjust your tax withholdings amount on your W4 so that the amount your employer withholds in taxes each month reflects the refund you will receive at the end of the year. By doing so, you can spread your federal tax benefits across your monthly paychecks. By updating your W4, in our example above, the $8,000 annual federal tax benefit can mean that your monthly take home pay will increase by over $660 every month.

Although a large portion of Americans qualify for federal tax benefits from home ownership, these benefits are not available to everybody. If you have income that qualifies your for the Alternative Minimum Tax (AMT) you may not be able to deduct your mortgage interest and property tax payments from your income. Before buying a home, you should talk with a Certified Public Accountant who is familiar with your taxes to make sure that you will be able to take advantage of Federal tax benefits.

Tax shelter is one of the returns associated with real estate investment that benefits income property ownership. Thanks to the tax shelter benefits provided by the tax code, a real estate investment can shelter some of its own income from taxation and occasionally shelter income received from other investment sources as well.

In this article, I want to introduce you to two allowable deductions for real estate investment properties that provide tax shelter.

The first of these deductions is for mortgage interest. The IRS allows you to deduct the interest you pay on the mortgage you obtained to acquire the income property. The benefit to real estate investors is that interest is really a cost associated with acquisition of property rather than operating it, and the argument can be made that tenants really pay the mortgage interest for the real estate investor.

The second source of tax shelter is through depreciation deduction, which the tax code now calls cost recovery, but we’ll continue to call depreciation for our purposes. In this case, the IRS allows you to assume that the buildings (not the land) are wearing out over time and becoming less valuable, and as such permit you to take a deduction for that presumed decline in the value of your asset.

Okay, now here’s what’s great about real estate depreciation.

Depreciation is a non-cash tax shelter deduction. In full compliance with the tax code, you get a deduction that is not an operating expense and therefore does not affect your cash flow. Moreover, depreciation can shield some or all of your property’s year-to-year income from taxation and in some cases when the depreciation deduction is large enough, it can even exceed the amount needed to shelter the property’s own income and provide tax shelter for other investment income as well.

Though you won’t find a simple formula for the tax shelter component of a real estate investment, here’s the idea.

Income less Operating Expenses = Net Operating Income

Then,

Net Operating Income less Mortgage Interest less Depreciation (Cost Recovery) = Taxable Income

Example: Let’s say you own an income-producing property that generates rental income of $48,000 and operating expenses of $19,200, leaving a net operating income of $28,800.

To calculate your taxable income, you would then deduct your mortgage interest and allowable depreciation from the net operating income.

Unless you have an interest-only loan, your mortgage payments are made up of both interest and principal. Only the interest portion is deductible, which we will say is $17,559.

The amount of depreciation depends on several factors: The useful life of the buildings as specified in the tax code, which is currently 27.5 years for residential property and 39 years for nonresidential property, and the percent of the investment real estate allocated to buildings and land. Only buildings can be depreciated, and for our purposes, we’ll say that the deductible amount for depreciation is $10,037.

Here’s the calculation: $28,800 – 17,559 – 10,037 = $1,204

In other words, you must pay Federal income tax on a taxable income of $1,204.

There are other components to tax shelter. For instance, you can typically depreciate capital additions over the same useful life, starting when they are placed in service. You are allowed to amortize closing costs associated with the acquisition of an investment property over the same useful life. And you can amortize loan points over the number of months of the loan term and write them off.

I kept it simple just to give you the idea of how tax shelter is associated with real estate investment and how it can benefit income property ownership. Hopefully, it helps. Here’s to your real estate investing success.