It is not a secret knowledge that investing in real estate generates wealth. However, the income you get from your real estate investments is taxable, and your investments may often lead to higher tax rates. Hence, learning about tax shelters for your real estate investments is vital. 

You should know your options regarding capital gains tax because it can take a significant portion of your income. Equip yourself with the knowledge about handling such expenses and using potential tax deductions to your benefit. 

In this blog article, we will explore the crucial things you must know about tax shelters and how you can use your real estate as the same. 

What is a Tax Shelter?

A tax shelter is a strategy employed by real estate property owners and investors to keep assets and minimize their current and future tax rates. The type of real estate investment or investment account may influence the type of tax shelter that an investor uses. Basically, you can lower your income tax rate by resorting to various tax credits and deductions. 

Your property investment can be an excellent tax shelter for many reasons. The advantages you can get include reduction of your mortgage interests, borrowing against home equity, recuperating the costs of an income-generating property through depreciation, and utilizing 1031 exchanges to defer capital gains taxes. 

There are also other common tax shelters aside from real estate investments. For example, you have 401(k) plans, 403(b) plans, pension funds, municipal bonds, and individual retirement accounts. 

The Difference Between Legal and Illegal Tax Shelters

It is pretty easy to recognize the difference between legal and illegal tax shelters. Just look at the end result or the benefit you can get from using either means of reducing your taxes. In illegitimate tax shelters, you simply avoid paying your tax obligations, not minimizing your tax expenses. Hence, they are illegal. 

Legal tax shelters allow you to reduce your taxes through means and instruments approved by the government or relevant authorities. In contrast, illegal tax shelters employ multi-layer transactions to hide the real identity of the owner. You can be prosecuted using illegitimate means of lowering or avoiding your taxes. 

Ways That Real Estate Investors Can Reduce Their Taxes

There are different ways that real estate investors can utilize their properties as tax shelters. How each of these strategies works will depend on the type of real estate investment and your financial situation. 

Depreciation or Annual Tax Deduction

The cost that goes into your investment property that produces income can be tax deductible. This refers to the depreciation or annual tax deduction, accounting for the minor damage that the property goes through over time. 

Using this depreciation method can help you minimize your capital gains tax payments. Rental properties can be depreciated over 27.5 years, which is what most real estate investors prefer. However, tax codes may vary by state. So, you should check the tax rules where you are residing. 

Mortgage Interest Deduction

In the first $750,000 of your financial obligation on your mortgage, you can deduct the interest payments from it on your tax returns. However, those mortgages incurred before December 2017 may have a higher limitation of $1,000,000,000. 

Tax Deferral on a Home Sale

If you successfully sell your home which used to be your personal residence, the profit from it is not taxable under the capital gains tax category. A single individual has a limit for exclusion of $250,000, and a married couple is $500,000. You can put your money in a 1031 exchange to reduce your capital gains tax if your capital gain is higher than the exclusion. 

It is an excellent strategy to trade up to lower your real estate taxes, especially if you are an investor living in an area where home prices are constantly rising. 

Borrow Against Home Equity

As you make mortgage payments on your investment property, you build up equity which you can borrow against to grow your investments. However, check the regulations in your state, as they may vary. 

1031 Exchange

The IRS code has a section providing for a 1031 exchange, where property investors can defer their capital gains tax from a home sale and use the equity to purchase another property of equivalent or higher value. However, this benefit is only applicable to exchanges of real estate properties that have been used for investment or business since 2017. 

Takeaway

Now you have an idea of how you can use your real estate property as a tax shelter. Holding an investment property can provide you with tax deductions to reduce your tax expenses. Therefore, avail yourself of legal tax shelter strategies, such as annual tax deduction (depreciation), 1031 exchange, mortgage interest deduction, borrowing against home equity, and tax deferral on home sales.