Real estate offers the potential for a compelling mix of cash flow and growth of invested capital. It provides returns comparable to those of other investment vehicles, such as stocks and bonds. You may shelter from taxes some or all of the income you earn from investments in real estate.
IRAs, 401(k)s, 403(b)s, and SEP Plans
For many investors, a tax-deferred retirement plan is an effective way to invest in real estate. You can indirectly invest in real estate with before-tax dollars by buying funds that own real estate or by purchasing shares of real estate investment trusts, which are like mutual funds that own buildings instead of stock. If you'd like to actually own real estate in your individual retirement account, you can also set up a self-directed IRA that allows you to use IRA funds to buy and manage investment properties. If you choose to use your tax-deferred account, remember that while you'll put money into the account to grow without taxes, you will need to pay taxes on the money when you withdraw it.
Roth IRAs operate much like regular IRAs, but with one important difference: You pay taxes on the money that you put into your Roth, but you don't pay taxes when you pull the money out. And all of your growth is tax-free. This makes a Roth an excellent place to invest in real estate funds or REITs that provide large returns. You must set up a self-directed account to buy actual properties.
Sheltering Income with Depreciation
If you buy real estate outside of a tax-advantaged account, you can take advantage of depreciation to reduce or even eliminate entirely taxes that you must pay on earnings from the investment. Depreciation allows you to write off a yearly allowance tied to the building's value and shelters income from taxes. For instance, consider a $400,000 rental house with a $120,000 down payment. If you have $29,900 in net operating income a year and make $15,306 in interest payments on a 30-year mortgage at 5.5 percent, you would have a net profit of $14,694.14. Since you'd be able to claim $14,545 in yearly depreciation, you would have a taxable income of $49, meaning you would owe essentially no taxes even though you put approximately $15,000 in cash and principal reduction in your pocket.
Tax-Free Trading With 1031 Exchanges
Unlike assets that are subject to capital gains tax, you can trade your investment property without paying any tax. The secret to doing this is to use the proceeds from your real estate to buy more real estate and to follow IRS rules to structure the transaction as a tax-deferred exchange under Section 1031 of the Tax Code. If you do this, you can carry your basis forward and avoid paying taxes. You can even do subsequent 1031s and indefinitely defer your tax liability.
- Bigger Pockets: The Self Directed IRA and Tax Free Real Estate Investing
- Commercial Partners Exchange Company: 1031 Exchange - Defer the Tax, Retain the Gain
- CNN Money: Picking the Sweet Spot in Real Estate
- The Motley Fool: The Right Stocks for Your IRA
- The Real Estate Foundation: Investment Real Estate – A Great Tax Shelter
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.