The effectiveness in protecting income from taxation is the true test of any tax shelter. Most real estate is purchased, at least in part, because of the tax benefits that accrue for the owner. Ownership of real estate can produce substantial tax savings that can transform a fair investment into a very good one. The goal is to protect large amounts of income – accruing from the property itself or from other sources – from taxation. Investment real estate can be very effective at doing this. Deductions that are available for most real estate investments include the following:
- Mortgage loan interest can be deducted to offset an equal amount of income. Borrowing $50,000 at 9% interest will yield an interest deduction of $4,500 during the first year of the loan, which can be used to offset $4,500 of income that would ordinarily be subject to income taxes. Regarding its effect on taxes, the interest deduction for investment real estate is the same as the interest deduction for a home mortgage.
- Property taxes levied against investment real estate and paid to state or local governments can also be deducted from taxable income. The deduction for property taxes you pay on investment real estate is treated in the same manner as the property taxes paid on your home, if you itemize deductions. The higher the property taxes you pay, the greater the tax savings you can achieve.
- insurance premiums for coverage of real estate investments are deductible from taxable income. Insurance premiums are not deductible for homeowners.
- Maintenance expenses are fully deductible in calculating the tax liability for a real estate investment. Expenses you incur for repairing rotting wood around the water heater or painting the deck are examples of costs that can be deducted from your other income, thus arriving at a lower tax bill. Maintenance costs can be quite substantial, especially for older properties (or properties that might be rented to college students, for example). Being able to deduct those expenses is a very important benefit of owning investment real estate, one which is not available to homeowners.
Improvements that prolong the life or increase the value of the real estate are treated differently from maintenance costs, however. While maintenance expenses can be deducted in the year that they’re incurred, improvement costs must be used to increase the cost basis of the real estate, thereby reducing any gain or increasing any loss when the property is eventually sold.
- Depreciation accounts for the decline in value of an asset over time, including most real estate. Depreciation decreases the accounting value (the value of the property as shown on financial statements) of real estate and at the same time offsets an equal amount of income from taxation, yet does not affect the market value of the property. Investors generally obtain maximum tax benefits by depreciating real estate as quickly as possible. Rapid depreciation offsets income and saves taxes sooner. Residential rental property currently must be depreciated equally over twenty-seven and one-half years, while commercial investment property must be depreciated over thirty-nine years.