How To Invest Tax Free

They say death and taxes are a guarantee in life, but some taxes can be avoided if you know the rules. Some taxes, like sales tax, are unavoidable. But income taxes can be reduced or eliminated, and this is the kind of tax put on your investments.

You can invest tax free by taking advantage of tax deductions such as rental property depreciation, business expenses and interest paid on loans.

I’ve significantly lowered my tax bill by investing in real estate, which offers enough tax benefits to provide returns that are completely untaxed. I want to share what I’ve learned with you, and then give you a great resource to continue your learning.

The Ways Your Investments Are Taxed

The first step to investing tax free is understanding how investments are taxed, at least from a bird’s eye view.

Unavoidable taxes

There are three basic types of taxes. Taxes on what you buy, taxes on what you own and taxes on what you earn.

Some taxes really are guaranteed, and you’ll end up paying them no matter how many tricks you have up your sleeve.

Sales taxes – if you are charged tax when you buy clothes or food, sorry but there’s no way around it, unless you want to travel somewhere that doesn’t charge sales tax or wait for a tax free holiday.
Property taxes – I get charged yearly for owning real estate and a motor vehicle. There’s no way around paying this tax, though it may be possible to file an appeal and lower your property tax bill.

You generally can’t avoid the taxes on what you buy and own, but you can avoid taxes on what you earn.

Avoidable taxes

When it comes to taxes on what you earn, there are two primary types of taxes:

Income tax
Capital gains tax

Income tax relates to taxes you pay based upon your regularly occurring income. So money you make from your job, dividends paid from stocks you own, rent paid from real estate, or income paid to you from a business you own are all types of income tax.

Capital gains tax is paid when you sell assets for more than you paid for them. Stocks are an easy example. If you pay $100 for a share and then sell it for $150 after 3 years, you have to pay taxes on the $50 you gained on that sale.

Investing to avoid taxes on earned income

The average person pays taxes on the money they earn, but there are ways to earn money and legally avoid paying taxes on that money.

First let’s look at the categorizations of how to avoid taxes, then we’ll look at some practical examples.

Tax deductions

Tax deductions are items that reduce your “taxable income.” So if you actually made $80,000 last year, but you were able to claim $15,000 worth of tax deductions, then you would only be taxed for $65,000 of the money you earned.

Examples of tax deductions include:

Standard deductions
Interest paid on loans
Property taxes
Charitable contributions
Medical expenses
Depreciation on investment properties
Business expenses

It’s possible to have total tax deductions that meet or exceed your earned income, and we’ll look at some examples of that shortly.

Tax credits

Instead of reducing your taxable income, tax credits count towards the actual amount owed on your taxes. So if you made $80,000 last year and owe $15,000 in taxes, then a tax credit of $5,000 would cause you to only owe $10,000 in taxes.

Here are some examples of tax credits:

Child and dependent care credit
Low income credit
American Opportunity Tax Credit (for higher education expenses)
Credit for elderly or disabled
Savers credit (for low earners contributing to retirement)

Tax credits can also be used to drop your tax burden down to zero.

Real World Examples

I think the best way to show the techniques of tax free investing is through examples. First I want to show you how the income I earn from my investment properties is completely tax free!

For a deeper dive into investing tax free, I recommend Tax Free Wealth by Tom Wheelright. This is the book that showed me how to invest to get the best tax benefits. And it also showed me that the government WANTS me to invest to get the best tax benefits.

Investment property (actually tax free)

When Kate and I started buying investment property, we didn’t fully appreciate the tax benefits it provides. Not only is the income we earn from our investment properties tax free, but it also eases the tax burden from our full time jobs.

Our investment properties afford us some serious deductions every year. The most important of these is depreciation.

Rental property depreciation is a tax deduction that is based on the value of the rental property. As of this writing it is about 3.7% of the value of the property.

So if your rental property is worth $100,000, then depreciation is a $3,700 deduction off your earned income. And as the building appreciates in value over time, so does the depreciation tax deduction.

The second big deduction is interest paid on the mortgage. This is more meaningful in the early years of the loan. But for a 30 year loan you’ll end up paying about as much in interest as you do on the principle loan balance. For our $100,000 property this would come out to somewhere in the ballpark of $2,500 per year (on average).

Then there are a few smaller deductions we can claim each year:

Cost of maintenance (plumbing, air conditioning repairs, replacement of appliances and anything else we spend money on to keep the building in service)
Property tax
Miles traveled to and from our properties

These deductions often add up to over $1,000 for a $100,000 property. Between all these deductions, we’re looking at over $7,000 in deductions each year.

Tax free investment?

The question is, how much would we earn from a $100,000 property in one year?

Based on my experience, I would expect to earn $4,000 to $6,000 in income from a property worth $100,000.

You can see that this is less than our $7,000 tax deduction. Quite a bit less!

If we earned $6,000 from the investment and deducted $7,000 from our taxable income, our taxable income would be $0.

So yes, it’s tax free!

Good returns, though?

You might see $100,000 and $6,000 worth of income and think “that’s only a 6% return on investment.”

And you’d be dead wrong.

Taking into account appreciation of the property, equity gained from mortgage payments and the power of leverage, you’re likely seeing close to a 30% return on investment for a good real estate purchase.

Roth retirement accounts (actually tax free)

One of the more popular, and thus well known, tax free investments is the retirement account.

I’ll just give a quick synopsis since you probably already know about retirement accounts.

Roth retirement accounts allow you to put money into a special account to invest (usually) in the stock market.

Normally, when you sell stocks you have to pay a capital gains tax on the amount of value those stocks gained while you owned them. But with Roth retirement accounts, you don’t have to pay capital gains tax when you sell your stock.

Note: this is true of non-Roth accounts as well, but non-Roth accounts will have income tax when you sell.

The only issue with these retirement accounts is there’s a limit to how much you can invest with them, so if you want to invest a lot of money, you’ll have to find other tax free investments.

1031 Exchange

Part of the ROI for real estate investments is the value you gain on the property from appreciation. That value can be realized either through selling the property or through using the value as collateral on some sort of loan (like a home equity loan or cash out refinance).

If you choose to sell the real estate, you can avoid (or defer) the capital gains taxes on that sale using a 1031 exchange.

This is a tax benefit unique to real estate. Taxes cannot be deferred on the sale of other assets like business and stocks.

Debt and interest tax deduction

Using debt, or leverage, as a technique to increase ROI on your investments is quite divisive among popular investors. Some say that debt should be avoided at all costs, and others preach the utility of debt.

I definitely believe debt is a tool that every investor should know how to use. I’ve talked a lot about how good use of debt can increase an investor’s returns. What I haven’t talked about much is how good use of debt can also lower an investor’s tax burden.

Let me show you what I mean.

Business investment with no debt

Let’s say you have $100,000 to spend on an investment and you decide to purchase a business. You should be able to buy a business that makes about $30,000 per year for $100,000.

If you do this, then you will have $30,000 of earned income at the end of the year.

You can claim deductions on money spent towards business expenses, but that’s pretty much it. Maybe you can claim $10,000 in deductions and your taxable income is $20,000.

Business investment with debt

Let’s say that you instead decide to use the $100,000 to put 25% down on a $400,000 loan and purchase a $400,000 business that makes $120,000 per year in income.

You’ll also have a $1,700 loan payment every month, so that $120,00 per year goes down to $99,000 after your loan payment.

Since you have a business that’s 4 times bigger, you’re able to claim a $40,000 deduction for business expenses (as opposed to $10,000).

And since you’ve been paying interest on your loan, you can claim an additional $16,000 deduction in your first year of paying the loan.

So after $56,000 worth of deductions your taxable income is $43,000.

When you didn’t use debt, your taxable income was 66% of your actual income, and with debt, your taxable income is only 43% of your actual income. That’s all because of your tax deduction from interest paid on the loan.

Say what you want about the risks associated with carrying debt to invest, but the benefits are completely undeniable if you use debt well.