Despite all the publicity to the contrary, tax shelters are alive and well. Here are some of the best ways to shelter your income from Uncle Sam.
Real Estate Shelters
If your Adjusted Gross Income (AGI) is $100,000 or less, you can deduct up to $25,000 in losses for rental property which you actively manage. However, the $25,000 loss deduction for rental property is phased out if your AGI is between $100,001 and $150,000. If your AGI is greater than $150,000, you cannot deduct any portion of your rental real estate losses (assuming you have no passive income).
The shelter strategy. If you plan properly, you don’t have to give up your deductions even if your income is more than $150,000. You can shelter income from taxes if you use your real estate for personal purposes instead of using it as rental property. No matter how high your income, your property taxes will be fully deductible and your mortgage interest deduction will be allowed to the first $1 million in acquisition debt and $100,000 in home equity debt.
How to use the shelter strategy. In the past, you could save taxes if you rented your vacation home and used it yourself for 14 days or less per year. If you kept within the 14 day limit, your property qualified as rental property and you could take the appropriate deductions. Using the opposite strategy may, however, save taxes.
If your AGI is over $150,000, consider using the property yourself for more than 14 days a year and treat it as your second residence instead of as rental property. This will allow you to deduct real estate taxes and mortgage interest payments.
It’s important to assess your individual situation to see whether using the property as a second residence or treating it as rental property will save you taxes.
You can usually take miscellaneous deductions only to the extent that they exceed 2% of your AGI. But many of these same expenses are 100% deductible business expenses if you report self-employment income on Schedule C. By deducting any expenses that are associated with your self-employment income as business expenses, you avoid the 2% floor for miscellaneous deductions. Items such as interest expense, travel costs, publications, and tax preparation fees can be fully deductible on Schedule C as long as you can attribute them to your (or your spouse’s) self-employment income.
Life Insurance Shelters
You can take advantage of most whole-life insurance policies to shelter income because some of your premium payment is used to buy insurance and some of it is used as an investment. Your return on the investment portion of your premium accumulates tax-free and taxes are deferred until you cash in the policy. Furthermore, if you die before you cash in the policy and your spouse or your children are the beneficiaries, the accumulated investment earnings are completely free of income tax.
You can no longer defer taxes on investment income from single premium annuities or from life insurance policies for which you pay a single large premium. However, some life insurance policies are now available for which you make seven equal premium payments for a period of seven years. The IRS does not consider these policies as modified endowment contracts and they can be used to shelter income.
If during your lifetime, you receive money – either from a distribution or a loan – from a life insurance policy which is considered a modified endowment contract, it is generally treated as income and is subject to income tax.
Tax-Exempt Bond Shelters
Income from tax-exempt municipal bonds is not subject to federal income tax. Current short term treasury yields, however, may give you a better after-tax yield than some municipal bonds.
Loan Interest Deductions
Interest on consumer loans is not deductible. However, don’t make the mistake of classifying all your loans as consumer loans. In some cases, loan interest for tax shelters, investments, and education may be up to 100% deductible, even if the loan is taken against an unsecured line of credit.
How you spend the loan determines its classification and the amount of interest which is deductible. By keeping track of the loan proceeds from the date you receive them until the date you spend them, you can determine the portion of the interest which is fully deductible rather than subject to the limit on consumer loans. For example, if you use the loan proceeds to make an investment, the interest may be fully deductible.