How Tax Shelter Really Benefits Real Estate Investors

By Author: James Kobzeff
Total Articles: 44
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Tax shelter is one of the returns associated with real estate investment that benefits income property ownership. Thanks to the tax shelter benefits provided by the tax code, a real estate investment can shelter some of its own income from taxation and occasionally shelter income received from other investment sources as well.

In this article we will explore two allowable deductions for rental income properties that provide tax shelter.

A deduction for mortgage interest is the first. The IRS allows a deduction for the interest that's paid on the mortgage obtained to acquire the income property. The benefit to real estate investors is that interest is really a cost associated with acquisition of property rather than operating it, and the argument can be made that tenants really pay the mortgage interest for the real estate investor. In other words, a tax deduction for mortgage interest really becomes an ongoing deduction for the real estate investor virtually paid for by the tenants.

Depreciation (or cost recovery as the IRS now refers to it) is the second source of tax shelter associated with rental property ...
... ownership. The IRS allows real estate investors to assume that the buildings (not the land) are wearing out over time and becoming less valuable and as such, permit a deduction for that presumed decline in the value of the asset.

Okay, but here's what's really great about real estate depreciation.

Depreciation is a non-cash tax shelter deduction. In full compliance with the tax code, you get a deduction that is not an operating expense and therefore does not affect your cash flow. Moreover, depreciation can shield some or all of your property's year-to-year income from taxation and in some cases when the depreciation deduction is large enough, it can even exceed the amount needed to shelter the property's own income and provide tax shelter for other investment income as well.

A simple formula for the tax shelter component of real estate investment property doesn't exist, but here's the idea.

Income
less Operating Expenses
= Net Operating Income

Then,

Net Operating Income
less Mortgage Interest
less Depreciation (Cost Recovery)
= Taxable Income

EXAMPLE: Let's say you own an apartment building that generates rental income of $48,000 and operating expenses of $19,200, thereby leaving a net operating income of $28,800.

To calculate your taxable income you would deduct mortgage interest and allowable depreciation from the net operating income. Remember, only the interest portion of the mortgage payments is deductible, and in this case we'll say that the mortgage interest is $17,559..

The amount of depreciation depends on several factors: The useful life of the buildings as specified in the tax code (currently 27.5 years for residential property and 39 years for nonresidential property) and the percent of the investment real estate allocated to buildings and land. Only buildings can be depreciated, and for our purposes, we'll say that the deductible amount for depreciation is $10,037.

Okay, here's the calculation: $28,800 - 17,559 - 10,037 = $1,204. The result is that you must pay Federal income tax on a taxable income of $1,204 (a lot less than you would have had without the tax shelter benefit of being able to deduct mortgage interest and depreciation).

Deductions for mortgage interest and property depreciation are the big ones, but just so you know, there are other components to tax shelter. For instance, you can typically depreciate capital additions over the same useful life, starting when they are placed in service. You are also allowed to amortize closing costs associated with the acquisition of income property over the same useful life, as well as loan points amortized over the number of months of the loan term.

We kept it simple just to give you the idea of how tax shelter is associated with real estate investment and how it can benefit income property ownership. Hopefully, it helps. Here's to your real estate investing success.
James Kobzeff is the developer of ProAPOD - proven real estate agent software since 2000. Create rental property cash flow analysis presentations in minutes! Go to => www.proapod.com