Every dollar saved in taxes is another dollar growing for you.
To illustrate the dramatic effect of erosion from taxes, imagine two investors who each invest $10,000. They both earn an 8% average annual return and are in a 30% marginal tax bracket. Both investors allow their gains to compound for 20 years. The first investor pays income tax at 30% each year on the gain, before reinvesting the remainder. The second investor structures his investments to postpone the gains from taxes. After 20 years the taxed investor’s assets had grown to $29,736 and the tax-sheltered investor’s assets were $46,610. That’s a difference of 60% more for the tax-sheltered investor.
With this kind of incentive to use sheltering techniques, let’s look at how to shelter your real estate investment gains.
Avoid taxable events
The biggest returns in real estate come from appreciation in property values. These gains are only taxable when you sell the property. One of the simplest tax saving techniques is to hold appreciating property, rather than sell it. Unrealized gains can grow and compound for years without ever being subject to tax. (See tax deferred exchanges, below.)
Under present law, beneficiaries of an estate receive a stepped-up basis for appreciated property, and that unrealized gain may never be subject to income tax.
Minimize current taxable income
In addition to deducting operating expenses from income, investors can also deduct interest on financing plus an amount for depreciation. In the case of many leveraged investments, there is little or no taxable income after deducting these expenses. Depreciation is special in that while it’s a deductible expense, it does not reduce the cash flow.
You can see from this example that a typical leveraged real estate investment might generate no current taxable income and no capital gains liability, until it is sold.
Use tax-free exchanges
The internal revenue code provides a special provision applicable to real estate that does not apply to any other type of investment. This allows an investor to sell one investment property and acquire another and postpone paying any tax on the gain from the sale – provided certain procedures are followed. The procedures are detailed and must be followed carefully, but it’s a tax postponing technique only available to real estate investors.
Combined, these strategies can greatly enhance the returns from investing in real estate, and provide a foundation for building substantial wealth.