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There are two allowable deductions for real estate investment properties that provide tax shelter. Tax shelter is one of the returns associated with real estate investment that benefits income property ownership. A real estate investment can shelter some of its own income from taxation and occasionally shelter income received from other investment sources as well due to the fact that the tax shelter benefits that is provided by the tax code.

Mortgage interest is the first of these deductions. You should be aware that the IRS allows to deduct the interest you pay on the mortgage you obtained to acquire the income property. So, what is the benefit to real estate investors? It is that interest is really a cost associated with acquisition of property rather than operating it.

Depreciation deduction is the second source of tax shelter (the tax code now calls cost recovery, but here let’s use the previous “depreciation”). The IRS allows assuming that the buildings (pay attention – not the land) are wearing out over time and it means they are becoming less valuable, and it means that you are allowed to take a deduction for that probable reduction in the value of your asset. Now let’s talk a bit about its advantages. So, firstly, depreciation is a non-cash tax shelter deduction. In full compliance with the tax code, you are able to get a deduction that is not an operating expense and therefore does not affect your cash flow. In addition, depreciation can shield some or all of your property’s year-to-year income from taxation and it can even increase the amount needed to shelter the property’s own income and provide tax shelter for other investment income in the cases that the depreciation deduction is large enough.

In order to make it easier to understand how it works let’s have an example. Imagine that you own an income-producing property that generates rental income of $48,000 and operating expenses of $19,200, leaving a net operating income of $28,800. To calculate your taxable income, you would then deduct your mortgage interest and allowable depreciation from the net operating income. Keep in mind that your mortgage payments are made up of both interest and principal in the case that you have an interest-only loan. Only the interest portion is deductible that is $17,559, for example.

Talking about the amount of depreciation several factors must be taken into consideration and they are: the useful life of the buildings as specified in the tax code (it is currently 27.5 years for residential property and 39 years for nonresidential property), and the percent of the investment real estate allocated to buildings and land. You should also remember that only buildings can be depreciated, so, let’s say that the deductible amount for depreciation is $10,037.

The calculation is the following:

$28,800 – 17,559 – 10,037 = $1,204

Simply saying you have to pay Federal income tax on a taxable income of $1,204.

Of course there exist other components to tax shelter. For example, you can typically depreciate capital additions over the same useful life, starting when they are placed in service. There is a possibility to amortize closing costs associated with the acquisition of an investment property over the same useful life.

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