Taxes: The Best Little Shelter in Town

You remember Everyman, the long-running English blockbuster? I'd like to start a sequel: Everyman Stings the IRS. It's an audience-participation story everyone can identify with. Everyman and his accountant sidekick, Everywoman, set out in quest of the perfect legal tax shelter—and find it. But only after learning the special words that unlock the riddle: rental property.

Everyman's nemesis, Everyone Else, wants him to think only in terms of what might be called the glitter shelters: movie syndications, cattle feedlots, offshore corporations, hydroponic farming, oil and gas deals, top-40 record syndications, etc. Such shelters have their place, certainly, but they are not for everyone—particularly not for those of relatively modest means.

Consider Everyman and Everywoman, a typical suburban couple: they have two Everykids and live in a decent but definitely not elegant home, with their pets Everydog and Everycat. They barely can scrape up a few thousand to get into any investment. They have their IRAs—to which Every Taxpayer should now be contributing yearly—and their home, which is Every American's first investment.

But what then? The various taxes—federal, state, local—skim off the rest of the couple's income, leaving them only with the looming certainty of college tuition they hope to pay for their children. The answer: they need to buy some rental "shelter"—perhaps another single-family residence, or maybe a duplex—with little or no down payment, to begin saving on taxes. Why rental property? Because it is truly the tax shelter for Everyone and can be used on both the grand and minute scales.

The entire concept is both simple and elegant. It is used by giant syndicates making multi-million-dollar investments in apartment projects with hundreds of units. And it is used by your neighborhood hippie, who just bought the shack down the street, fixed it up, and moved some of his hippie friends in.

What are the tax benefits? First of all, every penny you spend in the way of repairs, maintenance, improvements, and the like is immediately deductible on your next tax return (on the Schedule E) or will be depreciable over time. Having a neighborhood kid mow the lawn for five bucks means you get that much of a deduction. Painting some rooms? Paint, masking tape, brushes, scrapers, and so on are deductible. A new roof, a room addition, a new stove or refrigerator or water heater means added depreciation on your next tax return. (Generally, things that last more than a year are depreciated; all else is immediately deducted, or "expensed," on your return.)

In addition, a rental property virtually always creates a "paper loss" on your tax return. If it doesn't, something is probably awry, which your tax advisor can tell you about. The name of the game is to wipe out all rental income with the various deductions (on paper, of course) and come up with a hefty loss that will "shelter" your other income from taxes.

Generally, the expenses of owning and running a rental property will do this. Why? Because you're deducting your yard care, advertising to find renters, repairs, mileage to pick up the rent and to check on the property, painting, insurance, decorating, management and bookkeeping services, appliances, furniture repair and replacement, carpet cleaning, property taxes, interest, etc. In other words, everything you spend on that property is deductible, except for the portion of payments on the mortgage that goes to paying off the principal.

But here's the really great thing about rental property: in addition to all the above deductions, you also get to deduct the "paper expense" of depreciation on the building, appliances, and such—but not land, because it doesn't "wear out." And that is what creates the big loss when tax time comes around.

It used to be that buildings had to be depreciated over a life of 30 or 40 years, which meant comparatively meager yearly deductions. Now, however, President Reagan's tax program has allowed most buildings to be depreciated over a 15-year "lifetime."

So say you buy a little house for $35,000, and perhaps $10,000 of that is allocated to the cost of the nondepreciable land the house sits on. The house, then, will produce a depreciation deduction on your Schedule E of $1,667.67 each and every year for 15 years ($25,000 divided by 15). (This is assuming you don't use accelerated depreciation, which is a special case and another story.)

So you're doing all this stirring around: The house is making money from rental payments each month. You're using that cash to pay the mortgage and meet expenses, thus wiping out the extra income you're receiving. You're madly depreciating everything in sight on the property. Your total income is being driven down on paper by the resulting losses, and you're ending up with even more money because of the tax savings.

Something else great is happening too: the value of the property is (one hopes) increasing. After 15 years (or less, if the right deal comes along), the final scene in Everyman Stings the IRS is that the property is sold. At that point, all past depreciation is "brought back"—that is, the profit on the sale is adjusted upward to compensate for those 15 years of tax breaks you received. But guess what: you're only going to have to pay capital-gains taxes. What happened? Through the magic of depreciation, in addition to all the other tax breaks you got over the years, regular income was converted into capital-gains income! Good trick, huh?

Need I say more? Go then. Go now. Go forth and buy a shack, a duplex, an office building, the Taj Mahal. Rent it out. Save on taxes, Everyman. And keep more of the money that belongs to you.

Tim Condon is an attorney and a tax specialist practicing in Florida.