Presidential Debate

It has been widely discussed in recent days with the release of part of Donald Trump’s tax returns from 1995, that the rich are equipped with a number of unfair advantages when it comes to avoiding taxes and use various methods to shield themselves from taxes that the rest of us don’t have.

This got me to thinking, not many of us have a billion dollars to lose that we can carry forward for 18 years like the New York Times is claiming was possible through the loss the Trump recorded but many of us with some means can take advantage of smaller but still lucrative deductions that are available to everyone who is looking for them.

Wage Income vs. Investment Income

Probably the most unfair thing currently in the tax code is the way that the IRS treats wage income versus investment income. Let’s be honest, only relatively wealthy people have significant investment income. Be that income from dividends of stock, investments in a business or real estate. The rest of us work for wage income and we are taxed unfairly compared to those with long term investments.

Wage income is what you receive as a laborer from employment; from this you pay federal taxes, state taxes and FICA (Medicare and Social Security). Investment income comes from the sale of long term investments like stocks, selling a business or selling real estate.

In order to simplify this and show you the unfair nature of the way wages are taxed versus how investments are taxed, the chart below highlights the different rates paid by people of different income brackets based off of the 2016 federal tax brackets.  I used the married brackets here because; well I am married, sorry lonely hearts.

The column to the right has different rates for Long Term Capital Gains and Qualified dividends. These are just a portion of the different types of investment income out there so I will distinguish these from the other types of investment income that some non billionaire people may receive.

Different Types of Investment Income

Real Estate – This is considered passive income if you aren’t directly managing the property. I like to think of scenarios such as fixing up an apartment and renting it out to tenants but it can also include commercial real estate. In short this can be a big complicated investment or it can be a small time investment it all depends on how far you want to go here. Unfortunately, the income here is taxed at the normal income rates, but as we will see below, for the small time folks like us, the value here besides the income is found in the depreciation you can claim.

Capital Gains – There are two types of capital gains, short term and long term. Those rates you see all the way to the right above are for long term capital gains. That is anything held over 365 days so you want to be sure to make sure anything you are selling has been for at least 365 days to realize those rates. The short term capital gains are taxed at the same rates as wage income so be careful on this one.

Dividends – There are many types of dividends but for tax purposes you want to focus on qualified dividends. Qualified dividends are taxed at a lower rate because they consist of earnings that have already been taxed at the corporate level. The theory is that dividends are double taxed earnings, once at the corporate level and again when investors receive them. For this reason, since the Bush administration, they have been taxed at a lower rate. This excludes dividends that have not been taxed yet in pass through entities such as REITs, Business Development Corporations and S-Corporations.  What this boils down to is that qualified dividends end up being mostly from large mature corporations like GE and Proctor and Gamble. These may not sound like exciting stock tips but they can be useful for our purposes here.

Start Up Costs and Depreciation Are Your Friend

If you can create side income that is significant, it is worth setting up an LLC or an S-corp to take advantage of some of the advantages available to people who own these. You don’t need to be a big shot to set up one of these companies, sites like Legal Zoom can do it for a few hundred dollars. There are two advantages for the small guys that we can take advantage of, even with a small company.

Creating Debt – If you have cash on hand saved up to start your business and you don’t need a bank loan immediately (most banks won’t lend to start ups anyway) then there is a handy way you can use debt to recoup your startup costs tax free. Let’s say you start a business that requires a large upfront cost or requires some travel to do before the cash flow comes in. You can create debt to yourself for what you have put into the company  in the first year and when the profits start to be realized, the cash will be coming back to you as principal, on which you pay no taxes.

There is a rule that you have to charge interest on this debt but the IRS put’s the minimum at 3% which means you only pay taxes on the 3% interest you received over your principal.

Depreciation – Depreciation is how accountants deduct the normal wear and tear of an asset over time. For a business or side income, you essentially depreciate expensive capital goods that are used in the course of business. For example, if you buy a truck for a food truck business, you can’t deduct the value of that truck in one year, rather you have to do it over time, like over 5 years, so this expense will reduce your taxes going forward.

A useful way depreciation can be used as we will see below is on real estate. Residential real estate is depreciated over 27.5 years by the IRS and commercial over 39 years.

How Can A Normal Person Take Advantage of These?

So all that is great for a rich person with a ton of assets but doesn’t apply to you and me right? Just like this recent New York Times article pointed out;

Wrong. A friend of mine pointed me to a very thought provoking website the other day where they claim you can avoid taxes entirely and legally using what have described above and I will tell you how. This website is called http://www.gocurrycracker.com/

Take a look again at the chart I showed you with the federal tax brackets. It seems that almost all income is taxed, but we forgot about exemptions and deductions. In addition those 0% tax rates of investment income on the right are going to come in very handy in my example here.

The best way to show you how you can end up paying no taxes Trump style is through an example. Let’s assume you are a married couple with one child that files jointly. Let’s also assume that you have 2 rental homes worth $400,000 and $460,000 respectively. You paid for these as investment properties for which you took out loans to purchase them and then fixed them up. You now rent each of them out for $2500 a month with $1500 for taxes, insurance and mortgage interest. That nets you $2000 a month and $24,000 per year in investment income. Let’s also assume to fill your time, you took a part time job making $24,000 a year on top of that and you have savings in an index fund of $100,000 that throws off about $7,000 in capital gains and qualified dividends annually.

Now here is where it gets fun, at the end of the year, let’s assume you took the profit on those long term capital gains and dividends at $7000, made the $24,000 after costs on your rental properties and made your $24,000 in wages. Your income would look like this:

Now let’s look at how you can use exemptions and deductions Trump style, to wipe out that entire income. First you have the depreciation you claim on the homes. This is the value of the home at purchase minus the value of the underlying land over 27.5 years for residential real estate. This amounts to about $12,000 and $15,000 annually in our example and we will chose to itemize our deductions instead of taking the $12,600 standard deduction for married couples for 2016. Let’s also assume that we contributed the full $18,000 to an IRA to use the tax shield afforded by those contributions. Now, let’s see what exemptions and deductions the IRS will let you take:

There is an important caveat here, although we have $27,000 in depreciation we only claimed $25,000. The reason for this is that the IRS only lets you claim $25,000 in depreciation for income below $100,000. Once you surpass $100,000 the deduction decreases by $1 for every $2 you make over $100,000, this is a huge incentive to stay under the $100,000 limit. Also notice that we have wiped out the entire income of $55,000!

The only thing this family will end up having paid is the FICA on the $24,000 made as wage income which is 6.2% or $1,488. After the 401k contributions and FICA (both of which will eventually come back to you anyway) this leaves you with net take home pay of $35,512. Think that isn’t a lot to live off for a family? You would be surprised; there are a ton of people who do it all the time and live quite happy lives as www.gocurrycracker.com points out.

In addition, the more savings you have the more you can utilize those dividend and capital gains tax rates, in fact, if you keep your income low enough for tax purposes, you can save up towards that goal of replacing the $24,000 wage income with investment income. As noted above, that income can be up to $75,300 in 2016.

Another Example

Think about this for a second. That means to avoid taxes completely you don’t need Trump style money. Let’s look at another example.

If you were to make a combined 10% return on an investment of $448,500, that means you can realize these gains paying no taxes as long as your wage earnings are low enough. Let’s assume in this example you received a promotion at your job and now make $35,000, have the $44,850 in capital gains and qualified dividends and still have those houses earning $24,000 in rental income. Let’s also assume you monitored your taxes and gave a strategic $3,850 to charity towards the end of the year in addition to your annual $18,000 401k contribution.

Conclusion

A lot of reader’s may say this is not a realistic scenario but this is an example of how you don’t need to be a billionaire in order to take advantage of the tax code. All the information I researched for this article was readily available on the internet, I just had to go out and look for it. I will definitely being empowering myself going forward when it comes to my own tax strategy!

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