For investors facing significant capital gains or income taxes, write-off and tax credit investments provide methods to reduce or eliminate tax exposure. As opposed to deferring taxes with the 1031 exchange, 721 exchange, and Deferred Sales Trust, write-off and tax credit investments can cancel out the taxes owed. While tax write-off and tax credit investments provide significant tax benefits, it is important to distinguish between tax write-offs and tax credits and to note the trade-offs that are generally associated with these types of investments.
Tax write-off programs can offset tax exposure by directly reducing the taxable income that one must report to the IRS. In the same way that a business owner is able to deduct certain expenses from income (thereby reducing taxes), the IRS provides an investor the ability to make certain types of tax-deductible investments that apply against income and capital gains. Investors are able to deduct a portion or all of their investment from their income, thereby directly reducing their tax exposure for that year and keeping more of their money working for them.
The IRS allows tax write-offs to be utilized against active and passive income. Therefore, investors are able to offset their capital gains tax exposure with a tax write-off investment. For example, if an investor in the 28% tax bracket sells a property for $200,000 and has a $20,000 tax exposure, he would be able to invest approximately $72,000 into tax write-off investments to eliminate his tax exposure. Tax write-offs are also able to reduce the alternative minimum tax up to 40%.
The most common types of direct write-off investments include intangible drilling costs associated with oil and gas drilling investments. The IRS allows an investor to deduct 100% of the intangible drilling costs (IDCs) associated with an oil and gas program. Other write-off investments include alternative or "green" energy projects.
Whereas tax write-offs reduce taxable income, tax credits are a direct, dollar-for-dollar reduction in taxes owed. A $10,000 tax write-off program can reduce income by $10,000, thereby indirectly reducing the taxes against that income. Investors in the 28% tax bracket would have an additional $2,800 on their taxes by way of a $10,000 write-off. In the case of a $10,000 tax credit, the investor can directly reduce their tax exposure by $10,000. Tax credits also may be used to offset alternative minimum tax exposure.
Low-Income Housing is the most common type of investment that provides direct tax credits. Typically, tax credits can be taken over a 10-year period for the rehabilitation of an asset that exists primarily for the benefit of affordable housing for lower-income individuals. Other tax credit investments include carbon reduction, energy-efficient, and alternative, "green" energy projects and redevelopment. The IRS also has attempted to incentivize investors to revitalize areas devastated by natural disasters by providing tax credits for rebuilding projects.
The Tradeoffs of Tax Write-Offs and Credits
Whereas section 1031 and section 721 of the Internal Revenue Code primarily exist to encourage long-term, domestic participation and investment into the U.S. real estate market, tax write-offs and tax credits typically exist to incentivize investors to take certain risks that they otherwise may not have participated in without tax benefits. To put it another way, many times, tax write-off and tax credit investments may carry a larger amount of risk in the underlying investment or investment strategy, which requires additional incentive, such as tax benefits, to ensure sufficient investor demand.
In some cases, the underlying risk of a particular investment may be heightened by its dependence on ongoing government support for financial gain due to favorable alternative or "green" energy laws that are currently on the books. We generally encourage investors to avoid any investment that requires government subsidization in order to be a financially viable project. The tax benefits of an investment should be an additional feature--not the primary factor in the decision-making process.
Written By: Joshua Ungerecht