How do you tax shelter your cash flow?

Question

In the beginning it wasn't too hard. The property depreciation would usually shelter all the income from my rental properties. Now that these buggers are getting paid off the income is increasing and the depreciation doesn't cut it.

With my existing 6 figure salary all this rental income is just cream on the top for Uncle Sam to skim off. When I retire and my salary disappears it will be a very different story and not hurt so bad - but in the meantime ...

I've been thinking of some way that I can shelter this income. Note that my rental income counts as active income not passive so there are some more options open to me.

Some thoughts:

The first two are passive income shelters.

a) Buy an expensive rental in an awesome neighborhood with break even cash flow on it. Use the depreciation write off to shelter other income. Risky and speculative. If I could get in for 5% down (does anyone even offer those loans anymore) that would mitigate the risk somewhat.

b) Buy limited partnership shares in oil & gas exploration/drilling. They have some sort of mechanism like depreciation called IDC which can mean writing off 85-100% of your investment in the first year. E.g. Invest $40K and you get a $40K tax shelter.

The rest are active income shelters.

c) Max out every pre-tax investment option available to small businesses. Open my own 401(k) and HSA.

d) Make capital investments in my existing properties and use the 50% bonus accelerated depreciation (assuming that is still available this year).

e) Spend all the business income before it can be taxed. Remember that businesses pay tax after expenses - mere W-2 mortals pay taxes before expenses. This would probably mean setting up a C-Corp or something which would then suffer from double taxation.

f) Buy a Hummer H2 for the business and write off the entire cost as a capital expense.

I'm not sure I like any of these ideas but thought I would throw them out there anyway. What ideas do you have?

Dmitriy Fomichenko · Answer

Contributions to tax-deferred retirement account such as Traditional IRA or 401k come before taxes. They accumulate tax-deferred allowing you to grow your wealth much faster, compared to a taxable account. Contributions to Roth IRA or Roth 401k however come post-tax. You pay the taxes on contributions upfront, the growth and distributions however will be tax-free, forever!

Dmitriy Fomichenko · Answer

@Robert Steele consider self directed Solo 401k, this is a great tax sheltering vehicle. You can defer up to $50K per year from taxes and then use those funds for investing. All the gains/income/profits from investments owned by your Solo 401k would be sheltered from taxes.

Dmitriy Fomichenko · Answer

Will, the amount that you can contribute into Solo 401k depends on your earned self-employment income, and not related to any other retirement accounts you have. However, if you have employer 401k and making contributions there, your salary deferral will be subject to the same limit of $17,500 (or $23,000 if you are over 50). But with Solo 401k on top of that you have profit sharing component allowing you to shelter even more of your income.

Robert Leonard · Answer

Well @Robert Steele, I can't wait to be like you. "What do I do with all of this money?" That's awesome! :-) It looks to me like you're aware of all of your options, so it comes down to a matter of preference. I think you meant that Hummer part as a joke, but if not, if you really want one and the business can pay for it - get it! We do what we do so we can enjoy life and if your business can provide that for you, I think you've earned it! As far as spending the income before it can be taxed. I would just make sure that my assets were all well maintained and upgraded as needed to maximize their value in the long term. Nothing unnecessary, but just spend what you really need to, to keep them at their full potential. I have friends in the oil business and I only know enough to know that it's super high risk. With all of today's technology, its still a crapshoot when they drill. Unless you just want to say I'm in the oil business, you might have more fun with that money in Vegas. Beyond that, make sure a charity you believe in knows you support them by donating. If it bothers you a whole lot, slow down a little and take more vacations or do whatever it is that you enjoy to slow yourself down on making so much money that it hurts to pay the taxes!

Jeff S. · Answer

I hope you at least have an S-Corp or the LLC equivalent, @Robert Steele. You can pay yourself a dividend in lieu of some salary and avoid the associated payroll taxes. Any corporate income not legitimately expensed for business purposes is then expensed as salary. This avoids double taxation. The solo 401k deferral Dmitriy mentioned is actually around $100k if you’re married and can justify paying your wife a salary. You can still use the money to invest in RE, just from another pocket. And, if you chose to pay the taxes up front on some or all of the money, a Roth solo 401k is not tax deferred, but tax-free forever. In my view, these are the best most tax efficient plans around. If you really need a Hummer that’s one thing, but I’d never buy something just to lose money as a business write-off. Here, you’re spending a dollar to save 40 cents (or whatever you’re marginal tax rate is). I also hope you have a good CPA. We do our end of year planning right after Thanksgiving and tell our CPA whether we want to maximize our retirement contributions or not for the year and also give him our estimated year end P&L. He has magic spreadsheet that optimizes our payroll, dividends, 401k plan contributions, and resulting taxes. Jeff

Matthew Paul · Answer

Invest $75,000 in my business , I will show a loss after I buy that hummer

George Blower · Answer

@Major SappROTH IRAUnlike a traditional IRA, you can't deduct contributions to a Roth IRA but when distributed the basis is not taxable. The gains can then be distributed once the following is met:It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, andThe payment or distribution is:Made on or after the date you reach age 59½,Made because you are disabled(defined earlier),Made to a beneficiary or to your estate after your death, orOne that meets the requirements listed under First home underExceptionsin chapter 1 (up to a $10,000 lifetime limit).Contributions can be made to your Roth IRA after you reach age 70½ and you can leave amounts in your Roth IRA as long as you live.Roth Designated Account Solo 401kA designated Roth account is a separate account in a solo 401k that holds designated Roth contributions.A qualified distribution from a designated Roth Solo 401k account is excludable from gross income. A qualified distribution is one that occurs at least five years after the year of the employee’s first designated Roth solo 401k contribution (counting the first year as part of the five) and is made:On or after attainment of age 59½,On account of the employee’s disability, orOn or after the employee’s death.Nonqualified distributionsA distribution that is not a qualified distribution will be partially included in gross income if there are earnings in the account.The distribution will be treated as coming pro-rata from earnings and contributions (basis).The10% tax on early withdrawalsmay apply to the part of the distribution that is includible in gross income.

Brent Coombs · Answer

I believe the clue is in Jeff's "if you chose to pay the taxes up front" preamble. Welcome to BP. Cheers...

Major Sapp · Answer

@Jeff S. What do you mean funds in a Roth solo 401k are tax-free forever?

Robert Steele · Answer

@Jeff S No my rental business has no formal incorporation. Some of the assets are owned by my limited partnership but that is just flow through income for tax purposes. What I was getting at is that I have another business that is a LLC but taxed as a partnership. For that entity I could do what @Dmitriy Fomichenko suggested - I didn't realize it was so much $50K wow. I see there are some caveats so I will have to look into that further. So that takes care of sheltering that businesses income but I still have my rental income. @Robert Leonard yes the Hummer was tongue in cheek. Your advice about putting only enough capital into your rentals to get the most potential out of them is one I already live by. My properties are already in tip top shape pretty much so the amount I could shelter through capital improvements there is limited. I've looked into buying an expensive property at break even cash flow in the hope it doesn't depreciate and I can use the depreciation loss to shelter other income. But it is such a small amount it doesn't seem to be worth the risk. The lowest down payment I can find is 10% with FNM Home Path. If I pick up a property for say $300K, that's $30K down, and I can depreciate it at lets say $8000/year and my marginal tax rate is say 33% then that only shelters $2640/year. Which on a $30K investment is a pretty good return of 8.8% but probably not worth the risk. I think I need to stop doing my own taxes and find a good EA.