If you’re like most Americans, you don’t have a secret bank account in Switzerland where you stash money to keep it out of IRS hands.
Being out of the foreign tax-shelter loop isn’t such a bad thing. Uncle Sam recently signed a new tax treaty with that Alpine nation that should help U.S. collectors crack down on tax-evading owners of foreign bank accounts.
But there still are plenty of legal tax havens for law-abiding taxpayers. Even better, most regular Joe and Jane taxpayers can easily take advantage of them.
If you own a home, your actual shelter is probably your best tax shelter. Your house’s tax-cutting opportunities start as soon as you buy it and continue until you sell it.
You get deductions for all or part of your mortgage interest, points paid to get the loan, interest on certain home equity loans, and your annual property tax payments. These write-offs can help reduce your tax bill each filing season.
Then there is the profit on your home’s sale. That’s money the IRS can’t touch.
“The biggest thing in real estate that would apply to most people is the primary residence sale exclusion,” says Mark Luscombe, principal federal tax analyst at CCH in Riverwoods, Ill., a provider of tax information and services.
Under this tax code provision, up to $250,000 in sale profit for a single taxpayer, twice that for a married couple filing a joint return, is not taxed. “If you sell before your gain gets to that point, you can avoid ever having to pay tax on the residence,” says Luscombe.
The beauty of this home-related tax shelter is that it applies to every principal residence you ever own as long as you meet the IRS rules. The key requirement is that you live in the home two of the five years before you sell.
“There are instances where people will buy a fixer-upper and live there for two years while fixing it up and then sell it at a profit. And though a lot of that profit can be attributable to their sweat equity, they still qualify for home sale exclusion,” says Bob D. Scharin, senior tax analyst from the Tax & Accounting business of Thomson Reuters in New York City.
Investment real estate also offers some tax-shelter opportunities.
“One thing with real estate that puts it in that tax category as a more conventional shelter is that you can make a small down payment on real estate yet base your depreciation deduction on the entire purchase price,” says Scharin.
Along with the depreciation on the investment property, you also get mortgage interest and real estate tax deductions, as well as a write-off for upkeep and maintenance costs.
Of course, when you sell investment real estate, you will owe capital gains on the profit. But you might be able to delay that bill by taking advantage of another tax law.
Internal Revenue Code Section 1031 offers you a chance to postpone paying taxes on investment property by swapping it for another. Also known as a like-kind exchange, you sell a property and then use those proceeds to purchase another like one.
“Instead of recognized gain on the sold property, you roll it into new property and essentially reduce your cost basis in the new property by that gain,” says Dawn Greenberg, CPA and tax principal at Toms River, N.J.-based Cowan, Gunteski & Co.
When you eventually sell the new property, you’ll recognize the originally deferred gain plus any additional accrued since you purchased the replacement property. But if you don’t need the proceeds and just want to get rid of the property, says Greenberg, a 1031 exchange could help postpone an investment tax bill. In effect, you get an interest-free loan from Uncle Sam in the amount you would have paid in taxes.
While like-kind exchanges are often used by real estate investors, the technique is available for any investment or business property. If you’re interested in a 1031 exchange, consult an expert in the area. It can get complicated and there are strict rules, such as the requirement that any swap be made by a qualified intermediary rather than by the property owner. If you make a misstep in the exchange process, it could invalidate any tax benefits.
If you prefer more traditional investments, there are some tax shelter opportunities there, too.
“If bonds fit into your financial plan, look at municipal bonds,” says Luscombe. These instruments are issued primarily by state or local governments, or state-related organizations.
The tax benefit? Some states don’t tax interest on bonds issued by their municipalities. As for the IRS, municipal bond income is not taxed at the federal level.
Business tax breaks
Business owners, including those who set up a sideline to supplement full-time wage income, can use several IRS-approved tax shelters.
Section 179 of the tax code allows you to deduct substantial costs of business property purchases in the tax year they are made. Without this provision, the costs of items such as furniture and other equipment special to your business would have to be recovered through depreciation over several years, says Scharin.
If you operate your business out of your home, you could be entitled to a home office deduction. With this tax break, you can convert some of the maintenance cost of your home to tax deductions.
“The insurance on your house or if you need a new roof, a percentage of these costs would be deductible,” says Scharin. The amount is figured using the percentage of space that your home office represents.
A business owner also can hire the spouse and kids as long as they do real work for the company. “That gets additional income to them and provides deductions to the business,” says Luscombe.
You don’t have to be an entrepreneur to shelter income from Uncle Sam.
Greenberg says employees should take advantage of workplace benefits. Flexible spending accounts, to help pay child care costs and out-of-pocket medical expenses, allow workers to contribute money to the accounts before payroll taxes are figured. “You never pay taxes on that money,” says Greenberg.
That same pretax break is available for workplace 401(k) retirement plans.
Other outside-the-office retirement savings also can help you shelter income. Some traditional IRA owners might get an immediate tax deduction on their returns, along with a deferral of taxes on the IRA earnings.
A Roth IRA is great way for some folks to avoid tax. You don’t get any deduction for Roth contributions, but when you eventually take money out of the account, it will be tax-free.
And entrepreneurs have a variety of retirement plans — SEP and SIMPLE IRAs, Keoghs, Solo 401(k)s — that can help reduce their taxable business income as well as help prepare for eventual life after work.
With each of these various tax shelters, from your home to investments to your job to retirement savings, the IRS offers ways to hang onto more of your money. And when the tax man says it’s OK to keep money out of his hands, who’s going to argue?