Many people with substantial incomes from salaries, interest, and dividends legally pay no income taxes.
The secret? Ownership of depreciable real estate such as apartments, offices, stores, and warehouses. Any property held for investment or for use in a trade or business can qualify. Unfortunately, your personal residence is not included.
Thanks to the generous depreciation laws that are designed to encourage investments in such properties, taxpayers can eliminate or reduce their income taxes. Depreciation is an income tax bookkeeping entry for wear, tear, and obsolescence of the structure. The net result is legalized tax avoidance.
A true tax shelter is an investment where the investor saves more income tax dollars than he spends on the property. Depreciation is the best tax shelter of all because, to be entitled to this deduction, no actual payment of cash is required. Yet the owner can deduct depreciation, a non-cash expense, on his tax returns and thereby "shelter" some of his other income from taxation.
Suppose you buy a $100,000 rental building, perhaps a small commercial structure or a rental house. You estimate the property's non-depreciable land value is $20,000 and the depreciable structure is worth $80,000. Since it's an older building, you select a 20-year remaining useful life for it.
After paying all the property's expenses, such as property taxes, repairs, insurance, utilities, and mortgage interest, suppose the building produces $3,000 annual net income which you put in your pocket.
However, this $3,000 will probably be tax sheltered, thanks to the "tax magic" of the depreciation deduction.
To compute your depreciation deduction, using the simple straight-line method, divide the $80,000 building value by the 20-year estimated remaining useful life. This would give a $4,000 annual depreciation deduction. If a 25-year useful life had been selected, the annual depreciation deduction would be $3,200 ($80,000 divided by 25 years).
Subtracting the $4,000 annual depreciation deduction from the building's $3,000 net income gives a $1,000 "tax loss" or "paper loss." This theoretical, but not actual, loss is subtracted from your other income, such as job salary, to "shelter" $1,000 of it from income taxes.
If you own enough depreciable buildings, it is possible to shelter your entire income from income taxes. Many smart investors do this. Uncle Sam, in fact, encourages this result because the more people invest in real estate the better housed and commercially prosperous our nation becomes. Without depreciation, few people would invest in real estate.
Even though an owner shows tax or paper losses on his depreciable buildings, at the same time those properties usually go up in market value. When the owner eventually sells, his profit is the difference between the net sales price and his depreciated book value (called "adjusted cost basis" in tax language).
However, this profit is only 40 percent taxable (60 percent excapes tax) as a long-term capital gain if the property was owned over 12 months before sale. The net result is, thanks to depreciation, the owner has converted what would otherwise be ordinary income into long term capital gain.
To summarize, during ownership the depreciation deduction gives the owner tax sheltered income. At resale time, only 40 percent of the seller's profit is taxed.
Maximum depreciation is the goal of most property investors. To maximize depreciation from each structure, investors can (1) use accelerated depreciation methods and (2) depreciate each building component separately over its shorter useful life, rather than using the older composite method used in the example above. Your tax advisor can show you how to maximize your depreciation deductions using these techniques.