A lot of people have at least heard that investing in real estate
can be beneficial to your taxes. However, very few people know how it
works.
Cash Flow vs. Taxable Loss
First off, even if you have cash flow from an investment, the property can still have a “loss” for tax purposes. This is primarily through depreciation. How you figure depreciation is a topic for another time.
Where can you apply your tax shelter? That depends on whether you are “active” or “passive” in your investment.
Active Vs. Passive Investing
A taxable loss can offset earned income, if you can be considered “active” in your investment.T he IRS has several criteria for being “active”, including stuff like if you are personally liable for the debt, do you make decisions regarding operation, how many hours you spend managing, stuff that shows you really do have an “active” role. If you are “active” in the investment, and your property generates a taxable loss, it is called an “active loss.” Active income (your regular income) can only be offset by active losses. Talk to your tax professional to make sure you meet the criteria.
If you don’t meet the criteria, it’s a “passive” loss, and can only be used to offset “passive” income, stuff like mutual fund and stock dividends.
I have known people who were able to shelter 100% of their regular income through real estate investments.
How To Figure Tax Shelter
The benefit you get from the taxable loss is called tax shelter. The best way to understand how your tax shelter works is through an example.
Let’s say your regular taxable income is $100,000 this year. I don’t know which tax bracket that really puts you in, but let’s just call it 30% for our example. If you’re in the 30% tax bracket, that means you have to pay $30,000 in taxes.
Now, let’s say you own a property that generated a cash flow (money you can spend), but still had a $6,000 Taxable Loss (due to depreciation) and you are an “active” investor.
That means with this property, now your taxable income is
$94,000
and what you pay in taxes taxes is
$94,000 * .30 (30% tax bracket) = $28,200
That’s $1,800 lower total tax bill than you had without the property. If you’ve paid the $30,000 already through what you had removed from your paycheck, that means refund. For all intents and purposes, this is “found” money, money you can spend on that new TV, or whatever you want.
Bryce Beattie is a real estate investor and the webmaster at www.middleclassmillionaires.com
