Wealth Building Lessons

One of the basic criteria for the perfect investment is the ability to shelter your profits from taxes. If you can compound your money without having to pay taxes on it every year, you’ll become wealthier much quicker.

Normally investments like stocks, mutual funds and CDs are subject to taxes. But stocks and mutual funds can be sheltered from taxes by investing in retirement plans. Plans like a 401(k) or an Individual Retirement Account (IRA) avoid the tax hit when you put money into the account where it can grow tax-free until retirement. At that point, you must pay taxes on the withdrawals. However an account like a Roth IRA is the opposite. You pay taxes on the deposits, but the withdrawals are tax-free. Not only that, you need not wait until retirement either. After 5 years you can withdraw your deposits (but not the gains accrued) without penalty or taxes.

Other investments are tax efficient too. Municipal Bonds are free from Federal and some State taxes.

But my all time favorite is real estate. In order to encourage people to invest in real estate and provide housing for those who can’t afford it, the government provides tremendous tax benefits.

Just as businesses get to depreciate the cost of their equipment, investors get to depreciate their properties. You take the cost of your property, remove the cost of the land(since dirt doesn’t suffer any wear and tear) and you’re left with the value of the improvements. These improvements can be deducted over a 27.5 year period for residential property and 40 years for commercial.
For example, assume you buy a house for $350,000 and the value of the land is $75,000, then the value of the improvements is $275,000. Dividing this by 27.5 and you get $10,000. This is a depreciation loss (also called a phantom loss because its not really a loss) that you can deduct against your regular earned income. You can deduct upto $25,000 of passive income losses like this.

Contrast this with the stock losses of $3,000 every year and you’ll see why real estate is better. In stocks, you actually have to lose money and you’re capped at an annual deduction of $3,000 against your other earned income. But with real estate, your property might be appreciating every year and you can still claim a $25,000 loss!

Any profits you earn from the rental of your property or from other passive activities will be deducted against these losses, thus making them tax-free profits! If you own several properties, its not uncommon to have $100,000 in phantom losses to offset the profits from other activities, like selling a highly appreciated piece of real estate. Any loss that is over the $25,000 annual limit can be rolled over to next year.

If you’re earning $50,000/year from your job and have a home mortgage deduction of $15,000 and a passive income loss of $25,000, after taking out your personal exemption there’s almost nothing left to pay taxes on!

If that wasn’t enough, when you sell your highly appreciated property you can do what is called a ‘Starker Exchange’ or 1031 Exchange and defer paying taxes on the profits! You basically need to roll over your profits into another property within a certain time period and follow some other simple IRS rules. Its a great way to avoid paying taxes and leverage yourself into building wealth.

But wait, there’s more! You keep 1031-ing your property until you die and then your heirs get a step-up in basis and don’t pay any tax on the gains either! (of course its more complex than that, and assuming the tax laws don’t change).

While you’re capped at $25,000 in passive activity losses, there is an exception to this rule too! If you’re a real estate professional or if you have prove you’ve spent 750 hours in a year on real estate related activities, you can claim unlimited passive activity losses against earned income.

Another investment with good tax breaks are Oil and Gas Drilling projects. Since these are usually very risky investments, the government gives very good tax breaks to investors. You get to write off approximately 85% of your initial investment in the first year. The remaining 15% is spread out over several years. Not only that, but the oil revenue has a 15% annual depletion credit.
This also qualifies as a passive investment and is also limited to the $25,000/year annual deduction.

Of course, I’m not a tax professional, so I take no responsibility for wrong or out of date info. Just make sure you always consult a knowledgable CPA.

Here’s some recommended reading:

1. Perfectly Legal : The Covert Campaign to Rig Our Tax System to Benefit the Super Rich–and CheatEverybody Else
2. Aggresive Tax Avoidance for Real Estate Investors
3. Every Landlord’s Tax Deduction Guide

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