Real Estate Law (Still a decent tax shelter)
Directly owning real estate is historically, currently and perhaps forever more the primary source of wealth for most people. In addition, there are still important tax breaks to be had in owing real estate.
Real Estate Investment Trusts (REITs) have recently been favorable alternatives to common stocks. However, REITs are traded in the same manner as stocks and they do not provide the full tax shelter benefits one receives from direct ownership.
Rent control and tenants rights laws along with years of legislative reductions of tax benefits remain but these factors have settled out and are reflected in current prices. Add to this, low interest rates and good reason exists to review and update the tax benefits of real estate ownership which apply whether one leases out a single family residence or a multi-unit commercial property.
Using an LLC
Holding title is routinely being done by real estate investors through a Limited Liability Company (LLC) which in tax jargon is known as a “pass-through” entity. Unlike a C -corporation there is no double tax to be paid and tax losses flow through to the owners. The advantage of owning a property through an LLC rather than in one’s personal name is that it provides personal liability protection against claims arising from operating the property without putting in jeopardy any of an owners other assets. (Note that California LLC’s are subject to an annual fee based on gross income that ranges from $1042 per year if total income is $250,000 to $499,000 to $9,377 per year if total income is $5,000,000 or more.)
Leverage is an important part of tax wise real estate investments and with low interest rates it is optimum to put as little money down as possible and to finance the balance. Interest payments are a significant tax deduction against rental income.
Depreciation deductions for residential buildings occurs over a 27.5 year period and over a 39 year period for commercial properties. Deductions for items such as carpeting and furniture depreciate over 7 years, landscaping over 15 years and land value is not depreciable.
If one purchases a $450,000 residential duplex having a land value of $70,000 one can have an annual $13,800 deduction for 27.5 years.
Ideally, an owner will have a “paper loss” each year while being in fact cash positive. This “paper loss” is referred to as a “passive loss,” it is deductible up to $25,000 per year against other ordinary income provided that adjusted gross income (AGI) is under $100,000. This deduction declines to zero as AGI reaches $150,000.
Unused losses are carried to future years with all un-used losses being deductible when a property is sold. 1031 exchanges allow for the tax free selling of a property. If one sells for cash, profits are taxed at 20% capital gains rates (25% for the portion attributable to accumulated depreciation). No capital gains are paid when property passes to heirs at death.
Refinancing provides cash and a new interest deduction which ideally is on a property providing sufficient rental income to service a new loan.
For personal residences one can deduct mortgage interest payments on the first one million dollars ($1,000,000) of acquisition debt for a principal AND a second home combined.
In addition, one can deduct the interest on the first $100,000 of home equity debt irrespective of what those funds are used for.
On the sale or exchange of a principal residence an individual can exclude from income $250,000 of gain ($500,000 on a joint return).