TAX SHELTERS
When you hear the words tax shelter what are the first thoughts that comes to your mind? Maybe you think something illegal such as tax evasion or maybe you think of some complicated investment to avoid taxes. For many people these are the first thoughts that come to mind. These are common misconceptions but in reality a tax shelter is nothing more than a way to avoid taxes legally and in most cases they are simple and straight forward. A tax shelter is an investment in which the income generated is either tax deferred or tax free. Some of the more common legal tax shelters include tax free investments, rental real estate, and tax deferred investments.
- Tax Free Investments
These are the most common type of tax shelters. Tax free investments include municipal bonds, tax free bond funds, United States Treasury bonds, and other US Treasury securities. Municipal bonds can be issued by a state, a county, or some other type of local municipality. If you purchase a municipal bond in a state in which you live the interest earned on the bond is usually both tax free for both federal and state income tax purposes. If you purchase a municipal bond out of the state in which you live then the interest is usually tax free for federal purposes only. United States Treasury bonds or securities are only state tax free and are taxable for federal purposes.
- Rental Real Estate
Rental real estate or rental properties are terrific tax shelters. The reason why is that in most situations there is a loss generated from the rental property. When you own a rental property you report all of the income and expenses associated with the property on your tax return. Typically the expenses exceed the income and this generates a loss. The reason why expenses exceed the income is that the tax code allows you deduct depreciation on the property which increases total expenses. Where the tax shelter comes in is that depreciation is considered an artificial expense which means that there is no cash outlay and this depreciation deduction will usually push the rental property into a loss. Under the tax code this loss is considered a passive loss and is usually deductible against passive income if your adjusted gross income is less than $150,000. The loss is limited to $25,000 per year. If any of the loss is not deductible in the current year then the loss is carried forward to future years.
- Tax Deferred Investments
Tax deferred investments are not tax exempt meaning they will never be taxable, but the earnings are deferred or delayed until a future date in which they will be eventually be taxed. The common tax deferred investments include retirement accounts and annuities. Most retirement accounts are tax deferred in the sense that the taxpayer makes a pre-tax contribution to a retirement plan and receives a tax deduction. In addition, the earnings on the investment inside the retirement plan are not currently taxable until the taxpayer takes a distribution from the plan at which time the entire distribution becomes taxable. An annuity is similar to a retirement plan in that the earnings grow tax deferred. However, the difference is that annuity contributions are made with after-tax funds. There is no tax deduction. When the taxpayer makes a distribution from an annuity the only portion of the annuity that will be taxable will be the earnings that were deferred.