[Bill Smith]

I would like to understand tax shelters. Currently, I'm using itemized deductions with property tax, property mortgage interest and charitable contributions as the major factors; however, in a few years my mortgage will be paid off and this is reducing that itemized deduction. I'm retired; so IRA's and deferred income is no longer an option. Someone has mentioned investments like Publicly Traded Partnerships, REITs, State/Local Municipal Bonds, Royalty Trusts, but I don't know how they work or if there are any better ways of doing tax shelters.
Does anyone here know how these tax shelters work or if there are any better ones?

[bulksalty]

REITs are a shelter at the corporate rather than individual level, so there's no benefit for you there. (So long as they pay 90% of their income out as dividends the don't pay corporate income taxes).

Royalty Trusts and Partnerships are covered by similar tax law. You'll have to file a schedule K, which is difficult if you do your own taxes but an accountant should be able to whip it out but I'm sure it will cost you. They (in simple terms) allow you to recognize gains against your cost basis rather than against income. So your tax bill will be quite high when you sell the investment, but the income stream they provide is usually taxed less than it would be from a normal corporation. Royalty trusts normally pay a high dividend, but you'll have to pay attention to Canadian tax law as they receive a very favorable treatment that mostly accrues to Americans.

Muni bond interest isn't subject to federal income taxes, however gains are so trading them is sub optimal (be aware of this when you evaluate fund turnover). Some bonds do count against the AMT so make sure if you pay that, that you get the kind that don't. If you aren't expecting to be impacted by the AMT, you usually can earn a better return from AMT subject bonds.

A common suggestion would be to check to ensure that spreads are high enough, but refinance your house, and invest the proceeds in one of the above tax sheltered investments. Since the interest on your house is tax deductable, and the income is generally taxed at a lower rate, there's a decent chance to earn a nice spread.

However, that strategy is far from risk free, and would have been nearly catastrophic a couple of years ago (because muni prices fell dramatically). If a state were to default and you were concentrated in that state, you'd have to have other revenue sources to make your mortgage payments (and provide for your operating costs).

The preceding are things to think about and should not be construed as investment advice, nor are they offers to buy or sell securities.

[Bill Smith]

Thanks, that's a lot to think about. I'm in the US. Are your comments based on US or Canadian tax laws? I should always state where I'm from, seeing that discussion forums are international.

I was hoping not to have to refinance; since I was looking forward to paying off my house mortgage. Since I'm an individual and not in a business, it sounds like REITs and Royalty Trusts and Partnerships are not for me. However, possibly State/Local Municipal Bonds may be more appropriate.

I see that REITs are sold as stocks or ETFs. Is that the same thing as owning a REIT?

I've also heard that US Treasury Bonds might be worth looking into. What's your view on that?

[bulksalty]

They're based on US tax law, the most popular place to have royalty trusts is Canada, although some exist in the US (BP Prudhoe Bay and I believe there's a deepwater one). If you invest in one of the many from Canada, you have to be aware of Canadian tax law (which allows payments of dividends outside of Canadian tax law similar to a REIT in the US). However, because the US market is huge, many dividends flow to the US, and the Canadian legislature occasionally sees that as an issue.

REITs won't give you a tax shelter but may be a good investment. If you find a good one, they'll pay a nice dividend stream normally. Royalty Trusts are a great tax shelter for individuals, but the tax savings won't offset the extra headaches of filing unless you're careful. One of my favorites is Carl Icahn's partnership, it invests alongside him personally at times and holds things that he wants to shelter.

A good analogy is a REIT is to a REIT ETF as a company is to a mutual fund. A REIT is a specific company that owns certain assets (buildings or mortgages) an ETF is just a mutual fund that trades rather than cashing shares in and out of the firm. A REIT ETF is a cheap way to hold a diversified REIT portfolio. There's a good page to get info on ETFs at ETFConnect.com (looks like you have to register). If you're planning to invest less than say six figures in REITs, a fund (mutual or ETF) would probably be very wise. REITs are normally far more concentrated than most companies, because of the cost of a commercial building today, so additional diversification is good. Be cautious of both REITs and ETFs that have higher than average dividend yields, they're high because most investors don't trust they'll last.

Treasury bonds aren't really a good tax shelter (you don't normally pay state income tax on them but that's usually not most people's reason to shelter income). They can be a good part of an investment portfolio, since they're considered to be the lowest risk investment available.

[bulksalty]

Oops too many thoughts. Careful was supposed to be followed by these lines.

Partnerships and Royalty Trusts aren't worth the tax benefits unless you're investing a decent amount in each trust (after filing one year, I decided my personal limit would be $10,000 and since that would restrict my ability to diversify I'm waiting for now). The tax benefits are valuable especially if you can find something that is worthy of being a long term holding.