Gimme Shelter, Tax Shelter!

by Krantcents · 30 comments

Post image for Gimme Shelter, Tax Shelter!

A home is more than a tax shelter!  You may live in a condominium, cooperative, townhouse or a single family residence.  Whatever the type of home, it is your primary residence.  It may be your first tax shelter!  A legal method of minimizing or decreasing an investor’s taxable income and, therefore, his or her tax liability.  Buying a home decreases your taxes, but there is more!

Retirement Accounts

One of the best ways to reduce or defer taxes is contributing to a retirement plan.  Yes we moved from defined benefit plans to defined contribution plans.  Pensions are now rare and most have been replaced by 401 (k) plans.  In the even rarer instances that you can participate in both, you should.  A pension guarantees a fixed sum paid regularly or lump sum to an individual in retirement.  It is based on years of service and employee salaries.

A defined contribution plan permits participating employees to make contributions on a pre-tax basis.  This gives employees to voluntarily reduce their current salary or reduce their taxes to save for retirement.  In many cases, their employee may contribute a match to encourage the employee contributions.  There are various vesting requirements for the employer match based on individual company rules.  Common names for defined contribution plans are 401(k), 403(b), 457, TSP and IRA.  You are able to defer taxes and pay taxes based on what you withdraw in retirement after 59 1/2 years old.

There are limitations for deferring taxes in a defined contribution plan due to income restrictions, annual deferral limits and perhaps no employer match!  It is generally the first opportunity to shelter your income from taxes and allow it to grow without paying taxes until you withdraw the funds in retirement.  You will pay taxes when your income is lower in retirement.  Unfortunately, not enough people participate in defined contribution plans such as an Individual Retirement Account (IRA) commonly known as company 401(k).

Home ownership

When you buy a home, you are buying shelter and saving taxes.  You can deduct your mortgage interest and property taxes.  For most people, that means you can itemize your deductions.  The Internal Revenue Service is subsidizing home ownership!  The points you pay for your mortgage are even deductible.  You can even deduct points used to refinance your mortgage, although over time.  If it stopped there, you should be very happy with home ownership.

Home ownership allows you to build up equity in your property unlike renting your home. When you sell your home, you can even keep up to $250K in capital gains ($500K for married sellers) on sales of homes.  The exclusion requires that it must be your personal residence for two (2) of the last five (5) years.  The federal government encourages home ownership through low interest rates.  It is a great tax shelter and wealth building tool too!

Income property

Investing in rental property is one of the best shelters.  One of your best investments just got better.  You take your home and convert it into a rental property.  Instead of selling your first home, just keep it and rent it out.  You lived there five (5) years, and you probably can rent it out with a positive cash flow.  The home will continue to appreciate and someone else is paying for your expenses.  Over time you can acquire more rental properties and generate additional income.  If you live in each property two (2) out of the last five (5) years, the capital gain up to $250K ($500K if married) is excluded!

In addition, you can depreciate the property and shelter income.  Depreciation is an income tax deduction that allows the taxpayer to recover the cost of the asset.  This is based on the useful life of the asset.  Buildings, machinery, equipment, furniture, fixtures, computers, outdoor lighting, parking lots, cars and trucks are examples of assets that will last more than one (1) year.  I used this successfully when I owned income property.  It is a way of sheltering income.

Business

Starting or buying a business is a great way to shelter income.  Even a lemonade stand has equipment that should be depreciated.  The more assets a business has, the more depreciation to shelter income.  The stand, equipment and other assets can be depreciated.  The supplies, to make the lemonade is a legitimate expenses deducted before you can show a profit.  It is the net income or profit that we normally would pay taxes for can be reduced further using depreciation. In other words, you are saving taxes.

This favorable treatment of businesses is the federal government’s way of encourage business formation.  It is the expectation that as you make more money you will eventually pay taxes.  Depreciation is a way of recovering your investment in the business over time and sheltering some of your income.

Long Term Investments

When you sell an investment at a profit (owned a year or longer), you are subject to capital gains tax.  Investments held less than a year are taxed at ordinary tax rates.  Long term losses must offset capital gains.  Investments include stock, mutual funds, options, your home, or business.  2013 long term capital gains tax rates are still 15% for income up to $400.000 a year and 20% for taxpayers who earn $400,000 of ordinary income.  These lower tax rates are intended to encourage investment in stocks and businesses.

Final thoughts

You can complain about taxes or do something about them.  I offered a variety of options where you can shelter a portion of your income from taxes.  You can complain about taxes or do something about them.  I offered a variety of options where you can shelter a portion of your income from taxes.  You cannot eliminate taxes, but you can reduce them significantly.  A little tax planning can be worthwhile and you can save much more than the cost of planning.  What are you going to do ?  Complain about taxes or take advantage of a legal tax shelter?

Photo by: Brett Jordan

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{ 28 comments }

My Financial Independence Journey May 14, 2013 at 2:41 am

Tax avoidance is probably the thing that I’m the worst at. Because I’m trying to save up money as fast as possible, I miss out on a lot of the retirement account tax savings. I’ve thought about both home ownership and rental properties, but I’m don’t really like the area enough to make that kind of long-term commitment.

Krantcents May 14, 2013 at 6:57 am

The first tax deferral is a 401K. The next can be just buying a second home and renting it out. Easier yet, just keep your first home and rent it out.

CashRebel May 14, 2013 at 4:58 am

Great post! Im definitely going to refer back ti this when I have questions about tax sheltering a home. Unfortunately I haven’t taken advantage of any of these yet. Im a renter who has a profit sharing plan at work instead of a 401k.

Krantcents May 14, 2013 at 7:30 am

Thanks! Using the tax code to establish a business is a great way to increase income.

Holly@ClubThrifty May 14, 2013 at 5:59 am

I love the way that we benefit tax-wise for having rental properties. People see rentals as a pain, but they don’t see all of the ways that they can be beneficial.

Krantcents May 14, 2013 at 7:38 am

Very true! I just like the concept of someone else paying my mortgage and I get the benefit. The tax deductions just sweetens the deal.

Money Beagle May 14, 2013 at 6:49 am

I completely agree that it makes sense to pay the least amount of tax that you can. On the other hand, I don’t feel sorry when people do have to pay high taxes, because it means that they’re making a lot of money, and what’s to complain about there? :)

Krantcents May 14, 2013 at 7:39 am

I agree, the high income earners have a lot more choices so there should be no complaints.

Debt Blag May 14, 2013 at 7:07 am

Yes, that depreciation expense has come in handy several times. Importantly, it’s also accelerated so the biggest deductions come early on in the life of the property which is something to think about if you care about timing.

Krantcents May 14, 2013 at 7:40 am

Be careful, it is recaptured when you calculate your capital gains, although better than ordinary income tax rates.

John S @ Frugal Rules May 14, 2013 at 7:44 am

Nice post! We’re all about finding different ways to lower our tax responsibility and starting our business has added to that even more.

Krantcents May 14, 2013 at 8:05 am

Thanks! I think it is great that the government encourages business through tax breaks. Ultimately, it helps society and our economy too.

Kyle @ Debt Free Diaries May 14, 2013 at 9:45 am

I would love to take advantage of rental properties in the future. There are just so many tax advantages out there for business owners and income property owners!

Krantcents May 14, 2013 at 10:32 am

Real estate is just one element in an overall strategy. I just think it is great that government is offering tax incentives to invest in real estate. You can start with your home when you move to another home.

Kim@Eyesonthedollar May 14, 2013 at 1:47 pm

Oh, how I wish we’d kept our first home as a rental property, but hindsight is 20/20. We use all of those strategies. I also would include HSA accounts if you have a high deductible insurance plan. It’s not a huge savings, but if you are borderline on income levels, say you’re just above the Roth IRA income level, you can contribute to the HSA to lower your taxable income.

Krantcents May 14, 2013 at 1:54 pm

I didn’t use my first home either! I just stated investing in apartment buildings though. My medical insurance is pretty good, but I use a Flexible Spending Account. Although I itemize deductions for my tax return, I will never reach the 7.5% threshold so it make s better sense to use pretax dollars to pay for medical expenses such as deductibles etc.

Clare May 15, 2013 at 4:04 am

We can’t avoid it. Even online sales will likely to have tax now. What the hell does the government is thinking? I recently have a letter from the government congratulating me that my business has grown. And at the end of the letter says “we will tax you more”.

Krantcents May 15, 2013 at 7:00 am

There are many tax incentives to increase your business.

Andrew@LivingRichCheaply May 15, 2013 at 12:08 pm

I’m lucky in that I have a defined benefit and defined contribution plan (no match though). I would like to purchase real estate, but too expensive here in NY. It is definitely a goal though.

Krantcents May 15, 2013 at 12:53 pm

Real estate is expensive in Los Angeles too! That is where I invested years ago. Perhaps a partner may work for you.

Mike@WeOnlyDoThisOnce May 15, 2013 at 7:46 pm

Very informative. Do you think that, ideologically, any of these loopholes should be closed?

Krantcents May 15, 2013 at 7:52 pm

No, most tax breaks are just deductions. It encourages investment and expansion. Isn’t that a reason for a tax break?

Untemplater May 15, 2013 at 11:59 pm

I love contributing to my 401k. I also use flex spending and my employers commuter check program to use pre tax dollars. Every little bit of savings counts!

Krantcents May 16, 2013 at 7:24 am

Absolutely! No matter what your effective tax rate is, it is a boost in savings or spending.

Amanda L Grossman May 21, 2013 at 6:49 am

I was really bummed last tax season when I found out that we had to take the standard deduction even though we own our home. We had refinanced, and now much more of our money each month is going towards principle (hurrah!). In reality, I should be quite happy that we aren’t paying as much in interest on our home mortgage now!

Krantcents May 21, 2013 at 7:01 am

When I refinanced (9-10 years ago) with a 15 year mortgage, I suddenly realized I would have a lower interest deduction. It was great I was paying less in interest, but it was dramatic. Soon I will go to the standard deduction too because I will have my home paid off.

thepotatohead May 28, 2013 at 7:05 pm

I wish I had been thinking more about tax avoidance when I first started my job. I would have put alot more into my 401k which would have sheltered a bunch of income. The mortgage deduction is nice, but I’ll be happy when I no longer get it and have a paid off home :p

Krantcents May 28, 2013 at 8:59 pm

It is deferral, but still meaningful! It is one of the reasons, I max out my 403B, IRA and Roth IRA. The Roth is just a hedge in case I end up paying more taxes in retirement.

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