By Dr. James M. Dahle, WCI Founder
There are many ways for owners to increase their wealth that avoid 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 discusses mostly “first-world problems.” I fully expect the vast majority of my readers to eventually be multimillionaires. If you're offended to learn the rules, play by the rules, pay every dollar you owe in taxes but not leave a tip, and build wealth, 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 income tax. Let's talk about examples of non-taxable income.
Become a Homeowner
Perhaps the easiest one to understand is home ownership. A home is frequently derided as a liability and not an asset. I completely understand that idea, and I 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?
Well, they aren't what most people think. Most people think the big tax benefit is deducting your mortgage interest and property taxes on Schedule A. Well, with the new higher standard deduction ($27,700 for those married filing jointly in 2023), most homeowners are no longer itemizing. Plus, even for those who do, only the amount above the standard deduction is really deductible. Besides, the property tax deduction doesn't really exist for high earners who are paying more than $10,000 in state taxes already. Also, the mortgage interest deduction goes away when you pay off the mortgage. No, my friends, Schedule A is NOT where you find the main tax benefit of homeownership.
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 is not taxable at all. A married couple can swap houses every time the house appreciates $500,000 and never pay taxes on all that increase in wealth!
Business Ownership
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 $500,000 in additional earnings, for $5.5 million total). They would only pay taxes on $500,000 of that $5 million though. That's better than the effects of pretty significant leverage.
Buying Stocks
No, you probably don't own any WCI-like businesses, 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. As 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 $250,000/$500,000 exclusion of capital gains for which owner-occupied real estate qualifies. But the rest of this all applies AND you get the added benefit of deducting or depreciating 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 could 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 pay 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 the 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 $100,000 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 $900,000 in appreciation. But you need $200,000 to spend. So you borrow it against the asset at 6%. It costs you $12,000 a year for two or three years, and then you die. The asset is sold, and 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%-20% (really 23.8% when you include the PPACA tax). But those rates are far better than the 10%-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. Most of your return is deferred due to that tax-free appreciation we discussed above. But even the part that 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, you still qualify for the lower long-term capital gains tax rates as long as you've owned them for at least a year. 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 or 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
The income tax is not the only way that you 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 2023, the first $12.92 million ($25.84 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. There is a lot of talk about halving that amount, but that would still allow you to pass $6 million 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
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, carving out some of that after-tax income, 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!
This has accounted for the biggest shift in my wealth building over the last year for sure. Most specifically becoming the owner of rental teal estate properties. There are huge advantages to ownership and you are 100% correct that the best way to get there is to save and invest the money you make working to flip the script as soon as you can!
“Big hat no cattle”
Great Article Jim,
One note on depreciation recapture. For those who invest in syndication you can use passive losses that have either been carried over from that syndication, or another syndications passive losses from that same year of a liquidation event to offset both passive gains, as well as, can be used to offset depreciation recapture.
As a separate questions, what are some of the main things you can deduct to help with taxes specifically from an online business such as a blog, digital product, website etc?
Duke
Excellent point.
No particular tricks with online businesses. The less you earn or the more you have in expenses, the less you pay in taxes, but you still come out behind. Incorporating into an S Corp can help and the 199A deduction can be huge too. And of course a solo 401k.
When you sell a small biz, the seller isn’t responsible for capital gains taxes on the basis increase?
Completely unrelated, I’ve been trying to understand alternatives to rental real estate that ages out of the personal capital gains exemption i.e. it’s rented more than three years since residing in it. The simple version is paying capital gains. Another option is using the 1031 exchange.
The last idea I’ve read about, but can’t quite understand the repercussions and don’t even know whether it makes sense. The idea was selling the property to an entity which is controlled by the existing title holder. You’re supposed to be able to claim both the $500K personal exemption and use the 1031 exchange in the future. Aside from wondering how it would be financed, it’s clearly not an arms length transaction which seems like it wouldn’t be considered a legitimate sale in the first place vs. title transfer.
Ever heard of that particular strategy before?
That’s correct. You don’t pay taxes on basis.
I don’t think you can claim both the personal exemption and use a 1031 exchange for the same transaction. I’m not sure you’re explaining it well, but it sure sounds squirrelly the way you are explaining it.
Chris you DO pay taxes on the profit of selling price minus basis cost. ie on the ‘basis increase’ because the basis doesn’t actually increase, except by the amount you have depreciated the asset (? now I’m DEFINITELY out of my ballpark)
WCI,
Nice list of ways to save on taxes.
“There are a myriad of ways for owners to increase their wealth that do not involve generating any sort of taxable income…”
Not to nitpick, but the biggest tax for high-income people is the tax on the earnings themself.
In other words, you generally can’t “increase” your wealth without first making some taxable income.
It is sort of why I cringe when people say the Roth account is a tax-free accumulation of wealth, as it is no more tax-free than the traditional IRA, as both receive 1 level of tax forgiveness -either in or out.
Let’s take what could be your simple real estate example to drive home this point. Using an easy round number of 40% combined state and federal tax on your earnings. The numbers were $100k grows to $1m in 60 years – a very realistic 3.91% growth of real estate. Before you even sell it, what is the future tax paid on this investment, similar to if you put $100k into your 401k Roth over a couple of years. I would calculate the tax burden as follows:
To put $100k after-tax into real estate you first had to earn $166,667 in income and thus pay $66,667 in taxes @ 40%.
The lost opportunity to taxes over 60 years is thus $666,667 to make the $1m. Hardly tax-free wealth by any stretch of the imagination.
There is one investment that is truly tax-free if used properly and that is the HSA.
For truly tax-free growth of $166,667 @ the same 3.91% over 60 years would result in $1.667 million.
I admit, earning some tax-free income is always a goal, but let’s keep the whole picture in perspective. In this example, 40% of the growth of your earnings went to pay taxes, which certainly turns a 10 bagger gain into a 6x gain after taxes.
I think you missed the point of the post. The post is about tax-free wealth accumulation, NOT tax-free income.
Imagine you built a company that would sell for a multiple of 8X profits. If you make $100K a year in profits, it’s worth $800K. Now you figure out a way to make the company earn $150K a year in profits. The company is now worth $1.2 million. Your wealth just went up by $400K, but none of that wealth accumulation was taxable. If left to heirs or charity, it will never be taxed. You could even borrow against it tax-free (but not interest free).
It’s like what Peter Thiel did. How he was able to amass a $5B fortune just in his Roth IRA…. Hopefully everyone has the chance to do so!
Jim, this is probably one of the most critical articles related to wealth building, but the average EMPLOYED physician will have a bit of difficulty connecting with corporation/business ownership (buying into a partnership is not nearly the same). Hence i think the limited responses to articles like these.
This is what I did to get to a good place simply as a PCP. At times I had to get over my fear over not receiving a steady paycheck from someone else and my desire for liabilities that are marketed to us as the goals in life.
I too am a business owner of >14 years now. Revenues have grown steadily over that time, and now with several employed providers so (semi-)passive revenues are substantial. The beauty of a corporation is of course you expense first then pay taxes later, every year, whereas an employed provider pays taxes first and gets to spend whatever’s left over after taxes are already paid every 2 weeks. So many legitimate ways to soften tax burden as a corporation owner – limiting SS and Medicare taxes to salary and not on additional distributions, expensing business vehicles (not just mileage), affording your children employment taxed at their tax rate/tuition assistance as employees not taxable to them, business meals/attire/travel/computers//furniture/internet/TV/cell phones, expensing rent to self-owned real estate, etc. It adds up, but despite this our expenses are low operating out of a LCOL area, so household income is still multiple X average PCP while a business appraisal last year came in near 8 figures, given the healthy margins.
Real estate. Another corporation houses about 20K sq ft of commercial real estate on the main road in town for me. The biggest benefit is not that I lease the property in addition to occupying 25%, but that I lease it to other healthcare providers, generating a continuous additional source of new patients for us, allowing for continued expansion. Their businesses likewise benefit too, helping to ensure tenant longevity and stability. Annual real estate depreciation comes in nearly 6 figures annually against RE income for us. Then there are the benefits of 1031 exchanges, real estate professional for those qualified, property appreciation, unlimited deductions in commercial vs. $10K in residential, etc. Commercial real estate is clearly an asset, personal residence is more questionable IMO. I lean towards a home as a liability IMO given that it depletes one of money rather than generating it, given the limited appreciation of hard real estate relative to inflation. Buying from a desperate seller or a fixer-upper MAY be an exception in the end. I know you save money by not renting but so many physicians buy too much house and those savings wind up more than negated by mortgage interest, property taxes/insurance, utilities, maintenance/repairs. All of these items however are covered by NNN revenue for the owner of commercial RE.
Market investment. High income and responsible spending means more money for investment. I used to like 401k’s and IRA’s and still contribute the max. But I’m now thinking they’re more of a liability relative to lifelong investing in a taxable account which may be more tax favored for high earners with high effective income tax rates at RMD age. Not including Roth’s and HSA’s in this considerations, which I like more. Not only are long term capital gains rates much lower than high earner income tax rates, but there is no RMD with taxable accounts so the investments can continue to appreciate indefinitely and upon death step-up basis cab benefit family. Fidelity has a great tool that projects your estimated RMD’s at 72 if you continue to work and contribute to whatever age you plan to retire, based on your current balances and average market returns – for me they projected $2-4M/year RMD’s upon hitting age72 – that’s going to hurt because it’s in IRA/401k. Saving grace is that I’m big on charity.
Thru geographic arbitrage, fortunately I’m in a 0% state income tax state, low sales tax County and reasonable property taxes. I’m likely to get hit hard by estate taxes at some point so some day I think I’ll need to have more serious conversations with a CPA/attorney regarding legacy.
Anyway that’s how I accumulated assets that helps me keep more of what I earn, or at least defer taxes to enhance compounding in the meantime. It’s probably not unlike how most successful people use the tax code to their benefit.
Building significant wealth is really the result of small tidbits of financial literacy compounding over time rather than some big break or lottery winning (for most). Those tidbits can be found in the contents of this article – business ownership, real estate, market literacy while minding your taxes and limiting financial liabilities (outsized debts, poor income/depreciating asset spread). Spend intentionally. The powers that be advertise assets as things that are difficult to manage and not sexy, while liabilities are marketed aggressively to tug at our emotions – nice cars, brand clothes, exotic vacations, dinner experiences, oversized residences and the like. Hence I feel building wealth requires critiquing conventional wisdom rather than blind acceptance, like a bad clinical study to see beyond the smoke and mirrors (conditioned desires for that which is often objectively unimportant or unnecessary).
I think owning things is quite a good way to just not be tax efficient, but it’s just such a great way to build wealth as opposed to just working. While trading hours for dollars, you can add to your nest egg, but owning things is a great way to have it multiple on itself. As Jay-Z have said in The Story Of OJ:
“I coulda bought a place in Dumbo before it was Dumbo
For like 2 million
That same building today is worth 25 million
Guess how I’m feelin’? Dumbo”
Other than throwing down the money and waiting, the 23 million alpha is a great return (even pre-tax).