It is well known that taxes are the single largest expense that many people have in their lives. In many cases, this will even exceed the amount that is paid for the mortgage on our homes. As such, intelligently reducing our tax burden to the practical minimum becomes a highly important goal for us as investors.
Within the realm of tax shelters, one of the most powerful ones currently available primarily applies to real estate. This strategy is the tax-deferred exchange that allows investors to defer the capital gains on investment properties that are sold, and have the proceeds used to purchase more investment properties. By deferring the capital gains on the property, it will allow you to grow your capital base much more quickly. Furthermore, this deferral of gains places you in control of when (or if) they are recognized in your lifetime.
Contrast this against traditional financial products such as stocks are bonds. Short-term stock gains and bond interest are taxed at ordinary income rates, dividends are taxed at the special dividend rate, and capital appreciation on securities held over a year are taxed at the capital gains rates. If you are subject to Alternative Minimum Tax, these gains will likely be taxed at even higher rates. What we see from all of this is that traditional financial products have much of their value growth eroded by the impacts of taxes. None of these asset classes can have their capital gain taxes deferred like real estate. This is a powerful advantage that many investors would be well advised to take advantage of.
When legal entities are combined with this strategy, we have the ability to simultaneously protect our real estate assets from legal exposure, and enhance its long-term performance with the ability to defer capital gain taxes. An entity such as an LLC allows you to transfer ownership of a property out of your name to create a layer of protection in the event of a legal action. As intelligent investors, our focus should not only be on the amount we can gain, but the best way to protect ourselves from excessive losses.
One of the things that separates novice investors from experienced investors is that beginners typically focus on maximizing their potential gains, while experienced investors focus first on controlling their risk. The reason why this distinction is important is because future gains are always uncertain and frequently difficult to define. Conversely, controlling risk carries a position of prominent importance because it is the method by which we protect ourselves against catastrophic losses that compromise our ability to continue investing.
