How'd you like that clickbaity title? I'm very proud of that one. Hopefully, this post goes super-viral because of it. The title is actually an accurate summary of this post, however.
I hear statements all the time, usually on social media, usually from those on the left side of the political spectrum, and usually from folks who don't have even a basic understanding of the tax code, that go like this:
“[The] rich have many many legal options so they can get away with paying 15% or lower rate”
“The wealthy [don't pay] their fair share”
“[The wealthy are] dodging their taxes.”
When I pointed out that I actually do pay every cent of tax that I owe, the response became….
“People with financial know-how cheat those without.”
“The top 1% pay effective tax rates less than [the] lower middle class”
“Tax the 1%”“[Rich people don't work, they just] grant themselves bonuses”
“Most high net worth individuals…can reduce their tax as low as just 2%”
If you actually know how the tax code works, you're likely shaking your head at the statements made above just like I am. I'm not going to get into the fairness of our tax code in this post today, but will leave the determination of that up to the political process. Nor am I going to debunk the misstatements in some of the tweets above (hopefully they're pretty obvious to you by now). What I am going to do, however, is explain what the rich do to reduce their taxes and teach you how to pay less in taxes too, even if you aren't rich yet.
7 Tricks to Pay Less in Taxes like the Rich
# 1 – Depreciation
Buildings and equipment go down in value over time. In recognition of this fact, the IRS lets owners of these sorts of business assets take a deduction each year equal to an estimate of how much the asset went down in value that year. That seems reasonable, right? Structured properly, some real estate deals allow for more depreciation than the property even generates in income, basically sheltering all of the income of the property from taxation.
Since rental income isn't earned income, it isn't subject to payroll taxes either. Some newbie real estate investors, upon learning about this tax break, get a little too enthusiastic and feel like they're getting some sort of massive free lunch. They really aren't, because the building really is depreciating. That's why every few years you have to put a new roof on it or a new water heater in it and eventually the thing is bulldozed to make room for something new. But there is a little free lunch there.
The free lunch shows up when the depreciation is recaptured. When the asset is sold, all of that depreciation is recaptured. So if you bought the property for $200K, depreciated $100K of it, and then sold it for $300K, that $100K in depreciation is “recaptured” and taxed. The free lunch is that it is only taxed at a maximum of 25%. If your marginal tax rate was higher than that (28%, 32%, 35%, or 37%) then you come out ahead in that arbitrage. If your marginal tax rate is lower than that, then it is recaptured at your current marginal tax rate.
So for high earners, depreciation recapture does provide a very real tax benefit. Not only do you get to delay paying the taxes (there's a small amount of value there available to anyone) but when you pay them you pay them at a lower rate (a moderate amount of value there). Appreciation is also taxed at long-term capital gains rates, but we'll get into that more in the next section.
Another great aspect of real estate investing, of course, is that you don't HAVE to recapture the depreciation when you sell IF, within 60 days, you invest your proceeds from the sale into another property. In this “1031 Exchange“, the depreciation you took on the prior property is subtracted from the purchase price of the new property and then you can continue depreciating the new property from there. This allows you to delay the payment of the depreciation recapture tax even longer and if the new property is more expensive than the old (remember how you trade houses for hotels in Monopoly) you get to continue to reap the benefits of depreciation. In fact, if you continue to exchange properties every decade or so until you die, then thanks to the step-up in basis at death, that depreciation will NEVER be recaptured.
So, is this tax break only available to the rich? No. Anyone can do it, although it is more beneficial to high earners. There are two real estate investing benefits only available to low earners that kind of make up for it though.
- If you have a Modified Adjusted Gross Income below $100,000 you can deduct up to $25,000 in real estate losses against your ordinary earned income. High earners can't do that unless they're real estate professionals.
- As we'll note in the next section, lower-earning real estate investors may very well be able to stay in the 0% capital gains bracket.
# 2 – Capitalism
Sometimes on social media you run into people who are, frankly, communists. There's a reason communism didn't work, of course. It's not that capitalism is all rainbows and unicorns either. It's the worst economic system out there except for everything else we've tried so far. In capitalism, you put your money (capital) to work for you. Then you get paid for what your labor earns AND for what your capital earns. This is paid to you in interest, dividends, and appreciation of your assets.
Our society, through its elected representatives, has decided to encourage the long-term investment of capital, offering lower tax rates on qualified dividends and long-term capital gains (i.e. invested income) than on earned income. In addition to encouraging investment, this policy also acknowledges the fact that we pay capital gains tax on nominal gains—inflation is often a large chunk of that long-term capital gain and it really isn't fair to have to pay taxes on something that didn't actually increase in value. Interest, ordinary dividends, and short-term capital gains are, of course, taxed at ordinary income tax rates. In addition to the lower tax brackets available to long term investors, you also don't have to pay payroll taxes (Social Security and Medicare) on unearned income.
So, is this tax break available only to the rich? No way. In fact, high earners pay up to 23.8% on long-term capital gains and dividend income. Low earners pay $0. You too can dodge taxes like the 1%!
# 3 – Loans
Another tax-saving tactic occasionally employed by the wealthy is to borrow money instead of earning it or getting it from selling assets. The problem with this tactic is that it usually involves paying interest. If the interest paid is much less than the tax cost, it can make sense. Examples of this tactic include borrowing against cash value life insurance policies, borrowing against real estate, or borrowing against an investment portfolio (i.e. a margin loan).
Borrowed money spends just like any other money, of course, as most of us learned in medical school. However, if you're just delaying the payment of a tax, it probably isn't worth all the interest you'll pay. But if by delaying the tax you can reduce or eliminate the amount paid, then it may be worth it. For example, if you're going to be in a lower tax bracket later, it can make sense to borrow against an asset instead of selling it. If you can delay until the day you die and take advantage of the step-up in basis, then it can really make sense.
Is this tax break available only to the rich? No. Anyone can borrow tax-free at any time. Now the wealthy likely have more assets they can borrow against and are likely to be offered better terms on the loan, but the tactic is available to all.
# 4 – Retirement Accounts
The wealthy often sock money away into tax-protected accounts like Roth IRAs, 401(k)s/profit-sharing plans, defined benefit/cash balance plans, 529s, and health savings accounts. They can even, in effect, move money from a non-qualified/taxable investing account into a tax-protected account through the Roth conversion process (taxable plus tax-deferred = tax-free). Inside these tax-protected accounts, their money grows faster and is often protected from creditors.
As you are probably going to guess, this tax break is also available to low earners. In fact, a certain amount of earned income is required to make retirement account contributions. You can't use them if you don't do any work at all.
Low earners are actually much more likely to be able to put ALL of their retirement savings inside tax-protected accounts (rather than a non-qualified, taxable account) and don't have to hassle with the traditional IRA income deduction limit and the Roth IRA income contribution limit.
# 5 – Own Businesses
Wealthy people are much more likely to own businesses than the poor. Businesses generate wealth. Not only do they produce income, but if managed well, they become more valuable over time. A business is able to deduct all of its legitimate expenses and depreciate its equipment and property. When you own a business you can hire others. Since employees on average are not paid what they are worth, at least in the long-term (or the firm would go bankrupt), the business owner benefits from their labor as well.
Is this tax break available only to the rich? No. Anyone can own a business and deduct all its expenses. If they run the business well, they can benefit from their employees' work too.
# 6 – Take Distributions
Another tax break the rich take advantage of is to split their income into salary and distributions. By forming an LLC or a corporation and making an S election, the business is taxed as an “S Corp”. The portion of the income of the business that is determined to be distribution is not subject to payroll taxes like Social Security and Medicare.
Is this tax break available only to the rich? No. In fact, lower earners using this tactic may be able to save a much higher percentage of their income. A higher earner will only save the 2.9% Medicare tax but a lower earner may save 12.4% in Social Security tax AND 2.9% in Medicare tax.
# 7 – Carried Interest
Carried interest is the share of the profits of an investment paid to its managers. For example, a typical deal might be set up that the investors get an 8% preferred return and then any profits above that are split 80/20 with the managers. That 20% of profits paid to managers has traditionally been taxed at long term capital gains (LTCG) rates, even if it is paid out every year from a hedge, private equity, or real estate fund. The origin of this tax break is actually a fascinating bit of historical trivia—Sea captains were paid 20% of profits after a successful voyage. It was carried into oil and gas exploration ventures in the beginning of the 20th century and around the turn of the century, into the blossoming hedge fund industry.
The carried interest tax break has been the target of a great deal of criticism from both sides of the political aisle for years and so it was no surprise to see the 2018 Tax Cuts and Jobs Act limit it somewhat. In order to qualify for the lower LTCG rate on these profits, the assets must now have been held for at least three years (rather than the usual one year hurdle the typical investor faces). It is likely only a matter of time before this tax break is eliminated completely, although the private equity and hedge fund industries are among the biggest political donors on both sides of the aisle.
Is this tax break available only to the rich? It's worse than that. It's only available to the rich in the financial services industry. Although the door is wide open to you if you would like to start a hedge fund, the reality is that very few people with less than a seven-figure income will ever benefit from this tax break. Being able to use six out of seven of the “tax breaks of the rich” isn't too bad though.
What do you think? Which of the seven tax breaks of the rich have you implemented in your life? What plans do you have to implement some of the others? Comment below!