Crafting a Tax Structure that Works for Your Investments

Real estate investing is a great way to build long-term wealth. But along with potential returns come taxes—and more specifically, tax planning. Crafting a tax structure that works for your investments takes careful planning and understanding of both current and future tax liabilities.

When taking on new investments, investors need to consider the income tax rates and deductions available to them in order to determine the best tax structure for their specific investment. If done correctly, a savvy investor can mitigate their tax liability and maximize their overall returns.

Knowing Your Tax Rates

The most important part of setting up an effective tax structure is to know your marginal tax rate. If you’re an investor who owns a partnership, you will need to know both your personal marginal tax rate and the partnership tax rate.

The U.S. federal income tax is progressive. This means that your overall tax bill increases with your marginally higher income. It’s important to know this rate as this is the rate against which you can compare the rates of your investments. For example, a capital gain tax rate is typically much lower than the marginal tax rate, so it may make sense to investment in securities with capital gains over income tax.

Harnessing Capital Gains

One of the major benefits of investing in real estate is having the ability to defer tax payments by selling off assets. When you sell off investments with a capital gain, you’re essentially delaying your tax liability until a later date. Depending on the length of time that these investments are held, it is possible to qualify for long term capital gains rates—which are significantly lower than short term capital gains rates.

For example, in the U.S., long term capital gains rates would be 0, 15, or 20 percent, depending on the tax bracket in which you’re filing. The short-term capital gains rate is taxed at the same rate as ordinary income, so it is generally beneficial to hold investments for longer periods of time when investing for capital gains.

Utilizing Tax Deferment Tools

Tax deferment tools such as 1031 exchanges and 401(k)s are a great way to reduce both your present and future tax liabilities. With 1031 exchanges, you can rollover capital gains from the sale of an investment property into a replacement property. This defers all taxes until you decide to the liquidate your investment.

Additionally, investing into a 401(k) is also a great way to lower your tax bill, not just from this year but from years to come. Contributions to 401(k) plans are made with pre-tax dollars, and withdrawals are not taxed until after retirement. This can significantly reduce your present and future tax obligations.

Crafting an Effective Tax Structure

Crafting a tax structure that works for your investments generally starts with knowing your marginal tax rate. Once you have that information, you can start to look at different tax rate and deductions available in order to determine the best plan for your investments. Harnessing capital gains is a great way to reduce your tax bill, as long-term capital gains are taxed at significantly lower rates than short-term capital gains. Utilizing tax deferment tools, such as 1031 exchanges and 401(k)s, can also lower your present and future tax liabilities.

By taking the time to craft an effective tax structure for your investments, you can ensure you’re using the most tax efficient strategies in order to maximize returns and your overall net worth.