Tax Shelter for Real Estate Income

11 Replies

I'm just getting starting in real estate investing, have one property that nets roughly $2k every month.  The tax shelter is one of the things I like about real estate (since I have a day job as well).  And before going further, I'm in discussions with a tax professional but looking for anything myself or they haven't thought of from the BP community.

I guess my question is for folks that have been investing in real estate for years and built out several properties, knowing what you know now is there anything you would have done differently when you started?  For example, should I think about trying to put a portion of income in a solo 401k, or is that even possible?  Does it make sense to get a property each year for the depreciation, additional tax shelters?

My goal is to build a nice income to live from in 10 years but if there are ways to tax shelter the income for longer that is fine too.  Thanks for any insight!

@Justin Y.
A solo401k will not work in relation to a buy and hold rental business.
You need "ordinary income" for you to qualify to put away in a solo401k.

rental income does not qualify.

Basit Siddiqi, CPA
917-280-8544

Thanks for the comments, what do you mean by structure investments properly? Minimizing or not paying taxes on rental income, legally obviously, just making sure there aren’t simple things I should be doing.

I’ve read a lot about this. From what I’ve seen the easiest way to do this is to become a real estate professional, or be married to someone who’s a real estate professional. Then you can take unlimited passive losses which can be used to offset other income.

Other things I’ve heard of is using a captive insurance company, but that’s more for the big guys who make a lot of money (think 500k plus) or putting properties in a C or S Corp and paying yourself a dividend.

I could be wrong about a few of these but that’s the general idea. Not a tax professional, this isn’t tax advise, talk to a cpa

@Justin Y. I think what I'd be trying to do in your shoes is match the mortgage interest and depreciation exceed your net income.  If anything, look at your spreadsheet and plan to run "at a loss" for the next 5 years.  Over time rents will slightly increase while mortgage interest will slightly decrease but you can probably look at the "right amount" of debt to offset that (again, along with depreciation).  

It'll depend on what type of property you have, but there are number of tax shelters that you can use on real estate investements; that's the reason real estate is such a highly sought after investment and why so many have amassed their fortune in real estate. A few of the most common ways to limit tax exposure are depreciation (mortgage interest, property tax, physical property over a span of 27.5 years, major CapEx that can be depreciated at an accelerated rate, etc.), 1031 exchange and using a self-directed IRA (or solo 401k) to invest in properties. Note the last thing I mentioned is different than putting income from already owned properties in to your SD-IRA. I wrote a blog about this topic specifically for commercial multifamily, but a lot of the basic principals still apply:

https://www.biggerpockets.com/blogs/10191/67979-po...

This is by no means an exhaustive list, so I'll echo what others have said and advise that you seek out a CPA or tax strategist for advice an techniques.

@Justin Y.

The rental income will qualify as earned income if you are actively managing the properties.

Here is what IRS Publication 560 states:

https://www.irs.gov/pub/irs-pdf/p560.pdf

Net earnings from self-employment. For SEP and qualified plans, net earnings from self­employment is your gross income from your trade or business (provided your personal services are a material income­ producing factor) minus allowable business deductions

 To learn more about self-employment income rules, see the following. 

https://www.irs.gov/businesses/small-businesses-self-employed/self-employed-individuals-tax-center

@Justin Y.

If to you "tax shelter" means any method of reducing taxable income, then you may be focused on the wrong reason to invest in residential rental real estate.

There are three advantages to investing in rental property:  Appreciation, Cash flow, and Tax benefits.  Appreciation may not happen for quite awhile but is only realized when you sell a property.  Tax benefits are great but may change at the whim of Congress.  The really imporant advantage to investing in residential rental property is the Cash Flow.  

Seasoned rental property investers do not buy a rental property, instead, they buy the positive cash flow the property generates.  When you said your goal is to "build a nice income in 10 years", are you really saying that you want an income that will replace your current W-2 income (so you can either quit or retire)?   If so, then work on your acquisition plan -- don't worry about taxes.  

Do a cash flow analysis for each property you plan to purchase. How much does your first property really net annually? Whatever you have left over from your annual rental income after you have paid all the annual expenses for property taxes, hazard insurance, cleaning, maintenance and upkeep, repairs, property management, legal fees, advertising, mailing, postage, HOA fees, etc. is your annual cash flow. If that is a positive cash flow and if you can expect that same cashflow from each property you acquire, how many properties will you need in your rental portfolio to replace your W-2 pay? When you know that number, how many properties will you need to acquire each year over the next ten years to meet your goal? If the total number of properties is more than four, you may have to amass substantial cash reserves before you will qualify for conventional financing for your fifth through tenth acquisitions.

Once you have launched your acquisition plan, the income taxes tend to take care of themselves.  If you finance 75 - 80% of each purchase, your annual depreciation expense will most likely offset all of your positive cash flow.  For example, if your annual cash flow per property is $6000 and your depreciation expense is $6000, then you get to put $6000 cash in your pocket each year "tax free" because the depreciation expense offsets the rental income.   Depreciation expense is the best tax shelter going for the rental real estate investor.  If you repeat this with 10 properties, your tax sheltered income is $60000 per year.  

All the while, your tenants are paying the bills and paying off your mortgages.  You get to enjoy all the advantages of rental property ownership while amassing wealth from your tenants' rents.  Imagine owning a couple million dollars of real estate free and clear simply because your tenants were good enough to buy it all for you.  

If you plan to sell a property, a tax-deferred 1031 exchange is the next best tax shelter we have currently.  You can use a 1031 exchange to upgrade your rental portfolio and indefinitely defer capital gains taxes on the sale of your relinquished property.  Of course capital gains taxes don't come into play if you never sell.  Your heirs benefit by inheriting your real estate portfolio at its fair market value at the time of your death and avoid capital gains completely if they decide to sell.  You don't get to directly benefit from this tax shelter, but your heirs do. 

If the intent of your use of the term "tax shelter" was in the context of business entity, there are no tax advantages to be gained from the use of a business entity.  For residential rental property, you get the same rental expense deductions whether a business entity is in place or you hold the property in your own name.

Join the Largest Real Estate Investing Community

Basic membership is free, forever.