Now, I consider myself fairly well versed in personal finance, but the tax side of things still leaves me confused at times. Sometimes I read about investors buying real estate and taking a loss (operating costs > income?) from this investment, on purpose, to reduce their tax bill. I don’t get it–if I lose a dollar, and so reduce my tax bill by 40 cents… I’ve still lost 60 cents, haven’t I?
Not necessarily. Tax advantage can come from certain forms of income (often capital gains) being tax preferred either by having a different rate to other forms of income or allowing deferral of tax liablities.
Suppose I borrow to own a flat and the rent I receive is less than my loan repayments. I may still gain from this even if I lose for tax purposes if (for example, bearing in mind I don’t live in the US) I don’t have to pay tax on (all) of the capital gains that I make and more importantly if I can deduct the nominal (inflation inclusive) cost of interest payments now but I can defer any tax liability for capital gains I make as far into the future as I desire.
Timing is the key issue for this type of tax avoidance: if you can bring forward your deductions and defer your liabilities, you are effectively getting an interest free loan from the government.
Hawthorne, your capital gains in that scenario would be reselling the property at a higher price later on, is that correct?
Yep. There are of course risks in this approach: sometimes assets don’t appreciate. But it works if you can stand the risk - in a diversified asset portfolio you just realise the losses and hold on to the gains.