There are a myriad of ways for owners to increase their wealth that do not involve generating any sort of taxable income, that qualify generated income for a lower tax rate, or that at least delay that taxable income to later years. This allows for owners to dramatically decrease the greatest obstacle to wealth accumulation—taxes, and thus build wealth at a much faster rate.
I have written before about how Ownership Has Its Privileges and about how you actually want to become a capitalist as quickly as possible. While hardly risk-free, ownership is great in that when a business is successful, the vast majority of the profit accrues to the owners, not the employees. In a capitalist system, capital is king, so you want to do as much as you can to move from having to rely on your personal labor to being able to rely on your personal capital. Capital, like debt, works every hour of the day and night, 24/7/365. If you swap out “capital” for “interest” in the famous J. Reuben Clark quote you'll see what I mean:
“[Capital] never sleeps nor sickens nor dies; it never goes to the hospital; it works on Sundays and holidays; it never takes a vacation; it never visits nor travels; it takes no pleasure; it is never laid off work nor discharged from employment; it never works on reduced hours; it never has short crops nor droughts; it never pays taxes; it buys no food; it wears no clothes; it is unhoused and without home and so has no repairs, no replacements, no shingling, plumbing, painting, or whitewashing; it has neither wife, children, father, mother, nor kinfolk to watch over and care for; it has no expense of living; it has neither weddings nor births nor deaths; it has no love, no sympathy; it is as hard and soulless as a granite cliff. Once [invested], [capital] is your companion every minute of the day and night…”
It's a beautiful thing to come home from a vacation richer than you were when you left.
Not Here to Judge the Fairness of the Rules
First, a caveat. Lots of people think “the rich” don't pay their fair share. Warren Buffett famously talks about how his secretary has a higher marginal tax rate than he does. I'm not here to play judge, jury, and executioner about the rules in our tax code. I'm just here to tell you what they are. You can decide what you want to do with them, both in your personal financial life and in the voting booth. But this is a blog aimed at the high-earning professional and pretty much discusses nothing but “first world problems”. I fully expect the vast majority of my readers to eventually be multimillionaires. If you find the idea of learning the rules, playing by the rules, paying every dollar you owe in taxes but not leaving a tip, and building wealth offensive, this blog is probably not a good place for you to hang out.
The Key Concept: Earn Non-Taxable Income
The main idea I want you to take away from this post is that there are some things that increase your net worth that are not taxable income. If it isn't taxable income, you don't pay income taxes on it. Only income is subject to the income tax. Let's talk about examples of non-taxable income.
Become a Homeowner
Perhaps the easiest one to understand is home ownership. Now a home is frequently derided as a liability, and not an asset. I completely understand that idea and have written about it many times before. However, in some ways your home actually is an asset. Yes, your home is an investment. It can appreciate in value and it pays “dividends” in the form of saved rent. However, today we are talking about taxes. So what are the tax benefits of home ownership?
What Are the Tax Benefits of Owning a Home?
The main tax benefit of homeownership is that you do not pay taxes when the value of your home increases. Let's say you bought your home 10 years ago for $400,000. Now maybe it is worth $700,000. Your net worth is $300,000 higher than it used to be. Yet you never paid a dime in taxes on that $300,000, did you? No capital gains taxes are due until you actually sell the asset. But wait, there's more. Even when you do sell, the first $250,000 ($500,000 if married) in gains of a residence you have lived in for two of the last five years are not taxable at all. So a married couple can swap houses every time the house appreciates $500K and never pay taxes on all that increase in wealth!
Guess what? Business ownership works the same way to reduce taxable income. The lion's share of our personal wealth lies in the value of The White Coat Investor. Yes, we're trying to diversify that as quickly as we can, but that's the way life is for many successful entrepreneurs. When I started blogging back in 2011, The White Coat Investor had a value of $0. Now its value is much more than that. None of that increase in value has ever been subject to income tax, and if I leave it to my heirs, thanks to the step-up in basis at death, or leave it to charity, it never will be.
Since most businesses are sold at a multiple of profits, this increase in net worth can happen very quickly. Consider a business that makes $1 Million a year and is valued at 10X earnings, or $10 Million. That $1 Million is taxed every year, of course. However, if the business owners and managers figure out a way to make $1.5 Million a year, they will have created another $5 Million in wealth (plus the $500K in additional earnings, for $5.5 Million total). They would only pay taxes on $500K of that $5 Million though. That's better than the effects of pretty significant leverage.
No, you probably don't own any WCI-like business, but the same concept applies to every other business out there. And even if you don't start or completely own an entire business, it doesn't mean you cannot purchase parts of other successful businesses. Many of the world's largest and most successful businesses are publicly traded, and you can buy their shares in the stock markets either directly or via mutual funds (especially low cost, broadly diversified index funds, my favorite way to own them). Many of these businesses will continue to appreciate in value as they develop new products and services, raise prices on them, and reach out to new markets. So long as you do not sell your shares in these businesses, that increase in your net worth is not taxed. And if you leave them to heirs or charity, will never be taxed.
Tax Benefits of Real Estate Investing
Investment real estate does not qualify for the $250K/$500K exclusion of capital gains that owner-occupied real estate qualifies for, but the rest of this all applies AND you get the additional benefit of being able to deduct or depreciate all of your expenses on the property against the income from that property (and if you qualify for Real Estate Professional Status (REPS), against your ordinary income). Under bonus depreciation rules current at the time of this writing, you may be able to take over 60% of the value of your investment as depreciation in the year of the investment! The depreciation can “cover” a great deal of real estate income, income that would normally be subject to ordinary income tax rates, allowing that income to come to you tax-free. Yes, when you sell that depreciation is recaptured at a rate of up to 25%, but there is probably an arbitrage between your marginal tax rate and 25%. Plus, you have three other options to avoid having that depreciation recapture occur:
- Die (and pass it to your heirs income tax free thanks to the step-up in basis at death)
- Give it to charity (you get a deduction for the full value and neither you nor the charity pays capital gains taxes or depreciation recapture)
- Exchange it into another property (1031 exchange), further delaying the recapture until the second property is sold
Depreciate, exchange, depreciate, exchange, depreciate, die is the mantra of many successful real estate investors. If you don't sell, you get the appreciation (including the recapture of any depreciation) tax-free.
Borrowing Against Assets
In addition to scoring that tax-free increase in net worth from appreciation of assets, there are other ways owners can reduce their tax burden. One of the most common ways to get some spending money without selling an appreciated asset is to borrow against it. You can borrow against a taxable stock or mutual fund portfolio, against a cash value life insurance policy, against your home, or against your investment properties. Borrowing is always tax-free. It isn't interest-free (something the whole life salesmen seem to always gloss over) but it is tax-free. Sometimes the interest cost is far lower than the tax-cost would be. Imagine buying an asset for $100K at age 30 that appreciates to $1 Million at age 90. You're going to die soon and you want your heirs to get that step-up in basis, saving them capital gains taxes on $900K in appreciation. But you need $200K to spend. So you borrow it against the asset at 6%. It costs you $12K a year for 2 or 3 years, then you die. The asset is sold, your debt is paid off, and your heirs come out ahead by a couple hundred thousand dollars.
Lower Tax Brackets
Another way that ownership pays off is in the form of the lower qualified dividend and long-term capital gains tax rates. These rates range from 0% to 20% (really 23.8% when you include the PPACA tax). But those rates are far better than the 10% to 37% rates in the ordinary income tax brackets or the 21% rate in the corporate world. While the most tax-efficient stock is the one that pays no dividend at all (you can always “declare your own dividend” when you need the money by selling a few shares), most stocks only pay out 1/6-1/2 of their return each year as dividends. So most of your return is deferred due to that tax-free appreciation we discussed above. But even that part which is not usually qualifies under IRS rules for the lower qualified dividend tax rates.
Even if you do sell your stocks, mutual funds, or real estate, so long as you've owned them for at least a year, you still qualify for the lower long-term capital gains tax rates. Less paid in taxes equals more wealth accumulation. But if you do not own the asset in the first place, you cannot get the dividends nor the appreciation. Bonds, CDs, money market funds, mortgages, and savings accounts do not pay qualified dividends. That income is fully taxed each year at your ordinary income tax rates. You have to be an owner to get these tax breaks.
Wealth, Property, Sales, and Estate Taxes
Now, the income tax is not the only way that one can be taxed and there are a number of other taxes in the US that offset the income tax benefits that come through ownership. There has been some talk in progressive circles about instituting some kind of a wealth tax. While still quite unpopular, it faces a significant obstacle when it comes to implementation. It is simply very time-consuming, expensive, and fraught with error to appraise the value of illiquid assets every year. Undoubtedly, some assets will count and some will not, so the wealthy will simply shift assets from categories that count to categories that do not.
Property taxes are another way to tax the owners of capital. These are generally run by states and municipalities and thus are highly variable across the country. Again, not all property is taxed so one can simply shift assets from a taxed category to an untaxed category, or move your residence, business, and/or investments from a highly taxed location to a more lightly taxed one.
Sales taxes are often thought to be regressive, but they (especially when selectively applied to luxuries) are a method of taxing those who have a lot and spend a lot but do not generate very much taxable income.
Finally, the estate tax, while infrequently applied due to the fact that people live for decades, does put significant constraints on passing wealth from one generation to the next. However, in 2021, the first $11.7 Million ($23.4 Million married) in wealth can be passed free of federal estate taxes. That's still a lot of wealth that can be passed on, and under current law, that amount is indexed to inflation. Now there is a lot of talk about halving that amount, but that would still allow you to pass $6 or 12 Million to heirs estate tax-free if you live in a state without a lower exemption amount on their estate or inheritance tax. Above those amounts, estate tax brackets climb rapidly to 40%. However, if you and your spouse died with $100 Million designated for your kids, they would still get $69 Million. That amount can probably be increased significantly through good estate planning (and you could leave the entire $100 Million to your favorite charity). Wealth, property, sales, and estate tax laws are far easier to plan around than income tax laws, so the advantage still lies with the owners.
How to Get Capital
Now most of us don't start out our lives with much if any capital in our hands. The only way to get some is to make money the old-fashioned way–work. That mostly means working at a J-O-B, potentially paying taxes at those high ordinary income tax rates, and then carving some of that after-tax income out, NOT SPENDING IT, and putting it to work in long-term investments. Some of those investments might even exist inside accounts that provide additional tax protection like 401(k)s and Roth IRAs. It might also mean starting and growing a company. Or building a house or investment property. Or creating value in an existing business or property through your creativity and hard work. But the sooner you can move from being labor to being an owner, the sooner you can take advantage of our tax code, which is most definitely tilted toward capitalists.
What do you think? How has being an owner of assets benefitted your tax situation? What other techniques have you used to build wealth in a tax-free way? Comment below!