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
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.