One of the most effective ways to protect your income and your wealth is to utilize rental real estate as a tax shelter. I’ve been a property investor for over 15 years, and I typically pay next to nothing in taxes each year. Why is this the case? It’s simply because the tax code was written in favor of real estate investors. You see, the government realizes that property investors stimulate the economy, as well as keep the housing industry alive and well, and in turn, this can keep neighborhoods flourishing, and provide quality housing for families – everyone benefits.
With all that said, let’s dive in and learn more about tax shelters and how they benefit rental real estate investors.
What is a Tax Shelter?
A tax shelter is anything that is capable of legally reducing your taxable income – shielding your earnings, profits, and your wealth from being taxed heavily, resulting in a lower tax burden, or even owing zero to the IRS. This is accomplished through allowable deductions, and depreciation, as well as other tax benefits that are written into the tax code. There are many tax incentives that go along with owning a rental property, so it’s a great example of a tax shelter and used by investors to achieve a desirable ROI, as well as W2 high-income earners to offset their overall earnings.
How Does a Tax Shelter Work?
Generally, the more money you make, the more taxes you will owe. However, a tax shelter reduces your tax burden by lowering your net operating income (NOI). NOI is the income you make, minus deductions, depreciation, and other tax reductions. The final NOI you are left over with is what you would be taxed on.
For example, if you pull in $50,000 in rent checks for the year, just imagine what you would owe if you were taxed on that full amount. Luckily, the tax code offers many tax breaks to investors who own a tax shelter such as a rental property, so once you start applying those tax advantages, it starts chipping away at the $50,000, and the amount might be reduced to $10,000, or possibly a negative number where you would then owe zero.
Tax Shelter vs Tax Evasion
Although a tax shelter and tax evasion can bring about the same end result, which is paying less taxes, the methods used are entirely different. A tax shelter is used to lower the amount owed in taxes in a legal manner, as defined by the IRS and the tax code. On the other hand, tax evasion is used to lower the amount of taxes owned by using intentionally illegal methods that are considered a federal offense, and punishable by law. Tax evasion can include concealing bank accounts offshore, falsifying the accounting books, and the like.
How to Utilize Your Rental Property as a Tax Shelter
Now that you have a better understanding of what a tax shelter is, let’s dive into a few ways you can use your rental properties to hold on to more of your money instead of sending it off to the government.
1. Real Estate Tax Shelters Lower Taxes Through Depreciation
Wise investors know how to take full advantage of the tax shelter strategies that the IRS has allowed them to use, with depreciation being at the top of the list. This is especially true when utilizing a cost segregation analysis to determine depreciation values. When this strategy is used properly, depreciation can save an investor hundreds of thousands of dollars in taxes. Before we dive into cost segregation studies, let’s go over the basics of depreciation as it pertains to rental real estate.
Basic Depreciation
A rental property comes with a tax shelter benefit that the IRS refers to as depreciation, which allows an investor to depreciate the rental property building over the course of 27.5 years, writing off a percentage each year. This is in the tax code because, over time, as a building becomes older, it can wear out or depreciate, and the IRS allows you to account for this. However, as investors, we know that if a property is taken care of, it won’t fall apart and lose its value. In fact, it will most likely increase in value. We won’t argue with the IRS though, right? We will happily take our depreciation tax break.
For an investor to take advantage of depreciation in this way, they must own the property, and it must be income-producing, last more than a year, and it should have a determinable useful life.
Accelerated Depreciation
Basic property depreciation of the building itself provides an incredible tax savings, but the tax code allows for even more savings through accelerated depreciation. It enables investors to accelerate depreciation of non-structural items within and around the building, such as flooring, appliances, fencing, and so on, and the depreciation times for these items is shorter than 27.5 years. This is outstanding for those who don’t want to wait years for the full tax savings; taking advantage of accelerated depreciation is accomplished through what is called a cost segregation analysis.
What is a Cost Segregation Analysis?
How it works is instead of just depreciating the property itself over a timeframe of 27.5 years, a cost segregation analysis allows the non-structural elements such as the roof, driveway, kitchen cabinets, landscaping, and so on, to be reclassified and separated into accelerated depreciation timeframes of either 5, 7, or 15 years.
In IRS terms, it moves these elements out of Real Property – Section 1250, which has a depreciation time frame of 27.5 years, into a new tax classification referred to as Personal Property & Land Improvements – Section 1245, with shorter depreciation time frames. This allows the investor to keep more money in their pocket sooner rather than later. You can read all about how a cost segregation study works in our article titled, The Power of a Cost Segregation Study Can Save You Thousands.
Being able to do a cost segregation study on a rental property is what makes owning a tax shelter so incredible. Why? Because it significantly lowers your NOI, and therefore, your tax burden along with it. An analysis such as this is best done on new construction properties when everything is at its full value, and should be completed by an experienced cost segregation engineer.
Take a moment to watch this video that covers who can benefit the most from a cost segregation study:
Our Cost Segregation Program
Morris Invest has an outstanding Cost Segregation Program that was designed for those investors who want to significantly decrease the amount of taxes they owe, with the end result of having a high return on their investment. Additionally, investors who take part in our Cost Segregation Program typically save thousands of dollars, and it’s common to expect a 40% cash-on-cash return in the first year.
We actually provide a cost segregation analysis to qualified clients when they close on one of our new construction rental properties, which eliminates the need for the investor to hire a professional to do their own. If you think you might be interested in learning more about our program, simply schedule a complimentary call with our cost segregation team.
They can discuss all the tax saving benefits with you, as well as let you know if you are a good candidate for the program. For instance, if you would like to purchase a rental property through a retirement vehicle, then you won’t personally benefit from the tax savings since your retirement account will hold the title. But that’s ok, because in that case, we also have a Self-Directed IRA Program that may be a better fit for you. You can take a look at all our programs on the Morris Invest Team page.
2. Allowable Rental Property Tax Shelter Deductions
Almost every tax filer knows about the power of deductions, especially those who own a rental property. With each deduction you add, your NOI lowers, and in turn, so does your tax burden. Tax shelters that allow for a variety of deductions can help investors achieve a higher ROI that can be used to increase their wealth, buy more rental properties, or save for retirement.
Examples of Typical Rental Real Estate Deductions
| Property Insurance | Repairs | Advertising |
| Maintenance | Mortgage Interest | Legal Services |
| Utilities | Meeting Expenses | Property Management |
| Property Taxes | Closing Costs | Casualty Losses |
| Travel | Internet | Home Office |
Because a good majority of the work completed on a property can be tax deductible, you may be interested in taking a moment to read our article titled Rental Property Upgrades that Make a Landlord’s Life Easier. You can also write off property insurance, so if you don’t have this set up yet, we recommend heading over to the National Real Estate Insurance Group website to see if they are a good fit.
Property management fees are tax deductible, as seen in the above chart, so we thought it’s important to answer the following question that we often receive from our clients – Can I pay myself to manage my rental property? You can pay yourself to manage your own rental property, however, if you do, the IRS will consider it as income, and you will be taxed on the amount that you pay yourself. We suggest hiring a property management company to manage your rental. Read over this informative article that we put together titled, Reasons Why Hiring a Property Management Company will Put More Money in Your Pocket.
20% Pass-Through Deduction
The 20% Pass-Through Deduction, also referred to as a Qualified Business Income Deduction, allows those who pass their expenses through an entity such as an S-Corp, partnership, LLC, LLP, or if someone has self-employed income where they personally own the investment, to write off 20% of their taxable income.
If you’re not operating under an LLC, but would like to, contact Garrett Sutton of Corporate Direct. He has experience working with real estate investors who would like to set up an entity. Forming an LLC will not only make you eligible for the 20% Pass-Through Deduction, but will also provide you with many essential tax benefits, as well as legal protection.
How to Pay Yourself from an LLC?
If you’re new to limited liability companies, you may be wondering how you would pay yourself from your LLC. It’s pretty simple – you can take an owner’s draw against your profits by writing a check. It can even be a draw for the same amount each month, based on your estimated yearly profits. For tax purposes, make sure it’s clearly marked as an owner’s distribution.
Consult with a CPA for assistance to ensure you qualify and are getting the maximum allowable deductions – we use Tom Wheelwright of WealthAbility. He is the personal accountant to real estate tycoon Robert Kiyosaki, and is well known throughout the industry. You can also just pick up his book Tax-Free Wealth from Amazon; it will change the way you think about wealth and taxes.
3. Shield Your Profits with a 1031 Exchange
Although the current administration is proposing to put limitations on the 1031 exchange, it’s still worth discussing this tax shelter advantage because there haven’t been any changes as of today, and the program won’t be completely eliminated, just limited.
This tax-lowering strategy has been used by investors for many years, enabling them to quickly grow their portfolio, and their wealth. If the 1031 exchange tax break does become limited in any way, it would put some real estate investors at a financial disadvantage because it’s an incredible tool for legally deferring capital gains taxes, allowing the investor to instead use that money to purchase another property. The bottom line is that the 1031 exchange program keeps the real estate industry thriving.
What is a 1031 Exchange?
It’s an important vehicle for deferring capital gains taxes. This type of tax is owed when an investor sells an asset where the selling price is above the original cost price. Essentially, the investor will be taxed on the profit of the sale.
If an investor sold an asset such as a rental property that has significantly raised in value, you could only imagine the taxes they would have to pay on the profit of a large sale like this. However, since rental real estate plays out as a tax shelter, the tax code has been written to include special provisions for a 1031 exchange. These provisions allow an investor to defer paying the capital gains taxes on the sale if they use that money to purchase another like-kind property during a specific time frame.
This can be very useful when you want to trade in an underperforming property for a more lucrative one. There is no limit on how many 1031 exchanges you are allowed to do, so you can keep deferring those capital gains taxes until a final sale occurs where the money is not reinvested into another property.
Keep in mind that there are some important rules that need to be followed when doing a 1031 exchange. Watch our video, The 6 Rules of Using a 1031 Exchange, to find out what they are.
Grab a cup of coffee and dive into this video on the benefits of a 1031 exchange:
You can also read more about this topic by heading over to our 1031 exchange article. Additionally, if you’re not 100% familiar with capital gains taxes, please read our article that goes into the topic in detail, A Guide to Capital Gains Tax.
Take Advantage of a 1031 Exchange Before it’s Too Late
The current administration’s proposed changes to the 1031 exchange wouldn’t halt them altogether, but instead would limit the deferral amount to $500,000 a year, or 1 million for those who are married filing jointly. If this all goes through, it could mean the new tax rules would apply to those 1031 exchanges that take place after December 31, 2021. Along with this, it’s proposed that long-term capital gains taxes be taxed at the investor’s ordinary tax rate, which could be as high as 37-39 percent, instead of the current lower tax rate.
Because of the time it can take to do a 1031 exchange, if you want to avoid dealing with the limitation that may be imposed, and you have an underperforming rental property, it’s recommended that you start the process immediately.
Morris Invest has a 1031 Exchange Program where we can get the ball rolling for you, so you are taken care of before any changes are set in stone by the IRS. We not only take care of the 1031 exchange aspect of things, but also provide you with a cash flowing, new construction rental property that has a property manager assigned, and a tenant in place – it certainly doesn’t get any easier than this! Schedule a complimentary call with our team and we will make it happen for you.
For those who are interested, we put together a rental income tax guide that goes into more detail on lowering your tax burden.
Additional Morris Invest Articles
Now more than ever it’s important to be on top of your game. One way to make sure of this is to take in as much knowledge as possible in your area of interest, which we are assuming is rental real estate. With that said, below you will find our most popular posts on investing topics:
- Find out why investment properties are cheaper in Texas.
- Learn what the self-directed IRA prohibited transactions are.
- Every rental real estate investor should know about equity – learn more.
- If you want to create an estate plan, this post will get you started.
- Learn how to value real estate so you’re on top of your game!
- Find out how the BRRRR method can boost your wealth.
- Read about cash flow, its definition, and how it’s calculated.
- You can purchase rental properties with multiple investors – learn how.
- Stocks or real estate investments – which is best for you?
Resources for Jump-Starting Your Wealth Building
Most likely, you’re in the rental real estate business to grow your portfolio with the end result of creating wealth. If that is the case, then you will be interested in our 90-Day Bootcamp that gives you an outstanding financial education, as well as our Financial Freedom Academy. Additionally, we recommend downloading our free Freedom Cheat Sheet that will give you a good starting place to determine how many rental properties you will need to become financially free.
Create an Incredible Tax Shelter by Investing in Rental Real Estate
Rental real estate provides investors with an incredible tax shelter that can help them hold on to their wealth, and become financially free. It provides a way to shield earnings instead of sending them to the IRS. The more money you can hold on to, the more funds you will have to reinvest, grow your portfolio, and build up your nest egg for you and your family.
Morris Invest has been in the real estate investing industry for many years, and our new construction rental properties provide our clients with an outstanding tax shelter, a significant cash flow, as well as a way to recession-proof your investments. Feel free to book a complimentary call with one of our rental real estate experts so we can help you achieve your goals and dreams.
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