It was the fall of 1985, and I remember it well. I was 24 years old and just returned home with a passion for investing from the bookstore with a thick hard-covered book by Charles Givens called “Wealth Without Risk.”
The premise of the book was, you can make more and more money every year, but until you learn how to keep this money sheltered from money-hungry Uncle Sam, will you ever be able to amass any wealth?
The lesson was that wealthy people make lots of money and protect their assets by understanding how to use tax benefits to their advantage. The book discussed the difference between tax evasion, which of course is wrong, illegal, and will not serve you long term, and tax avoidance, which is smart business and the key to creating wealth.
For several years now with our investing, as we approach fall, my wife and I have been setting up a tax planning strategy meeting with our tax preparer. With three of the four quarters already completed, we have a pretty good handle on what income and expenses for the year are going to be.
We simply add another 25% to the income and expenses of our investing to get a pretty good calculation as to where we will stand at the end of the year. With this information in hand, we can be more purposeful and invest appropriately during the last few months of the year to minimize our tax for the year.
Pre-tax planning allowed me to convert tax owed dollars into investing dollars
There is nothing more frustrating than hearing from your tax person that you owe taxes and have to pay more. Instantly, you start processing in your mind all the wonderful things you would rather spend that money on – such as investing in real estate — than an intangible tax expense that does not excite you.
Coming up with the money for down payments was always the problem in my investing, until I learned I already had the money. I simply needed to stop spending it on taxes and start spending it on investments.
Real estate investing offers some of the best tax shelters available
I had already developed a passion for investing in real estate, as I had been fortunate enough to realize some nice profits from previous investments.
Now understanding I can actually leverage these investments even further with smart tax strategies excited me further. I learned several tax strategies over the years that help reduce tax liabilities.
Have you ever had a long- term strategic planning session with your tax adviser?
I always strongly encourage investors to talk with their tax professional from a long-term strategic planning perspective. This is one of the most overlooked pieces of diligence when investing in real estate.
Taking your paperwork in year after year will simply get you tax preparation. Take the time and have a strategic long-term planning session. A great tax person should have already suggested this, but do not wait for an invitation. Ask for this strategy session.
It can save you thousands of dollars which can be used for your investing.
Among recent tax benefits used by seasoned investors is component depreciation
Most investors depreciate their investments to create deeper tax deductions. Depreciation is where you are allowed to devalue your investment property for tax purposes over a course of time. This duration of time varies for the different components of the property. Essentially, different parts of real estate have different depreciating schedules. When you and your tax person assign values to the different components you can often create more tax savings.
Let’s break it down
The land value: Land never depreciates, so the value of land cannot be depreciated.
The building: The building, according to the IRS, can be depreciated over 27.5 years (residential property) or at a rate of 3.63 percent per year. Most people do this.
Personal property: Things like appliances, air conditioners, and carpeting can be depreciated over 5 years or 20% per year. Some investors do this.
Land Improvements: Things like driveways, shrubbery and fences can be depreciated over 15 years or 6.6 % per year. Very few investors do this, primarily because they have never been exposed to it.
The average investor simply depreciates the value of the building. On a $100,000 investment property that looks like this: Let’s assume the land represents 10% of the value.
- Land; $10,000 = no deductions
- Building value $90,000 X 3.63% = $3,267 deduction
- Total deduction on this depreciation schedule is of course $3,267
A tax savings option:
Using the same assumptions of a $100,000 property and (though it varies by location) let’s say for easy math that the land value is $10,000, the personal property value is $10,000 and the land improvement value is $10,000. That leaves the building value at $70,000.
- Land value $10,000 – no deduction
- Personal property $10,000 x 20% = $2000 deduction
- Land improvements $10,000 X 6.6% =$660 deduction
- Building value $70,000 X 3.63% = $2541 deduction
- Total deductions $5201
The second option, using component depreciation, actually provides for an additional $1,934 in tax deduction. Now, for fun, assume you have 10 properties just like this, or perhaps a million dollars’ worth of property; you would have increased your tax deductions by $19,340 .
You can easily see that by strategizing with your tax professional and by doing pre- tax planning you can indeed take hold of your wealth building objectives. It is important to point out that everyone has different objectives, which is why creating complete and total transparency and strategy conversations with your tax adviser is paramount to building a maintaining your wealth.