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!
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 Pensions are now rare and most have been replaced by 401 (k) plans.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).
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!
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.
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.
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