“Rich people deserve to pay less taxes”. That might sound insane today, but it is true if you think about it from a certain perspective. Whether you think this is the right way, things should be or not, the tax system is set up in a way where you can take advantage of the incentives the IRS is providing for you.
It’s a system and like most systems, if you understand the rules, you can maximize your value. If someone hires professionals to navigate the most strategic rules to a system, an accountant in the tax system, and then that individual implements those strategies, they actually deserve the rewards of their efforts.
Whether we agree with the system as a whole today or not today, we are going to explore the strategies behind it.
Table of Contents
STRATEGIES THE WEALTHY ARE USING TO PAY ZERO IN TAXES TODAY
First, let’s go over the very basics. The US tax code today is progressive. That means it’s set up so that the more money that you make, the more money that you pay. In theory for each taxpayer, the percentage amount of tax that they owe is higher as their income passes a certain threshold. This is what’s meant by people discussing bumping up into the next tax bracket. So why does it seem undeniable that rich people pay a lot less taxes than others or sometimes even zero taxes at all? It seems that way because it’s true.
Most people earn most of their income as salary and wages. The employer withholds the appropriate taxes from your earnings and pays them directly to the IRS. So when you file your tax return, it’s actually a reconciliation of that account. In the same vein, if you paid too much, you get a refund, and if you didn’t pay enough, then you get a bill from the IRS and possibly a penalty for not, for not paying the amount you’re supposed to.
All that said, the taxes due on ordinary income increase according to how much you make per level, but the secret for wealthy people is that much of their income isn’t ordinary. It comes from investments and other sources that are taxed differently.
- CAPITAL GAINS ARE VALUABLE
Many wealthy people and others get their income through capital gains. A capital gain is an increase in the value of something that you own.
For example, if you buy a house and the value increases, that difference is a capital gain. The same is true if you buy a stock or a hotel, even if the value of those assets increases that reflects a capital gain. These gains are subject to income tax, although at a lower rate than imposed on ordinary income.
For example, the very top tax bracket for income in the US for wages is 37%. The same amount of money obtained as a long-term capital gain has a maximum levy of 20%. If you see the difference right there on the numbers, straight out of the gate right away, that’s a benefit. You could save almost half the tax obligation if your income is a capital gain instead of ordinary income. Again, wealthy people make most of their money typically from capital gains.
So they’re saving almost half on taxes right out of the gates, but it gets even better since there are ways to delay and even avoid paying that tax.
- DELAYING AND AVOIDING TAXES.
Suppose you buy real estate and the value increases during the time that you own the asset. If you have owned the property for over one year, the increase in value is considered a long-term capital gain, which is eligible for a lower tax rate as that status of a long-term capital gain because that value is still in the asset.
That means your investment could actually double and you wouldn’t be taxed on the increase unless and when you sell the property. But even when you do sell the property, there are ways to defer or reduce the taxes you need to pay at that time.
One of the most advantageous sections of the tax code that’s used by wealthy people allows people who inherit property to avoid paying any tax on the property’s increase in value before they inherit it.
For example, if your parent or your best friend or whoever buys commercial real estate for $50,000 and owns it for 30 years, let’s say it could be worth over $1 million easily today. If that person then sells it, they could pay 20% of the value increase, which would be about 190,000. Instead, if the owner then bequeath it to someone, that person inherits that asset at the stepped up value, which is the value that they receive that asset at at that time.
So the new owner doesn’t owe taxes on the value until they sell it. So that’s a pretty drastic way of pushing those taxes back while they are owed at some point. Moving that back generationally or huge gaps in time, even decades, delays that tax significantly and maximizes it using the stepped-up basis approach. Another incredible advantage of the tax code is using the 1031 exchange.
- COMPOUNDING THE SAVINGS USING 1031 EXCHANGES.
Suppose the owner of that commercial real estate property holds onto it for a few years and then decides that they don’t want to own a shopping center anymore, but instead would prefer let’s say multi-family or industrial. If they sell that shopping center that they were given and then go and buy an industrial complex, they will need to pay capital gains on the appreciation if there was some of that shopping center that they experienced and benefited from. Instead, what they can do under the 1031 strategy is execute the 1031 exchange, which is also called a like-kind exchange. This allows them to swap that shopping center that they got for the industrial complex or any other investment property if performed correctly. With the use of an accommodator and things that maintain compliance for you can allow the investor to defer payment of capital gains taxes by reinvesting the entire proceeds from the sale into the replacement property.
Not surprisingly, the IRS has definite and very strong rules governing the use of the 1031 exchange. For example, the investor must use a qualified intermediary as mentioned before, to manage this entire process. So don’t try to do this at home and maneuver through this difficult process without guidance and without a professional. The 1031 exchange is also subject to strict timelines that the IRS has identified and the investor may not have access to the proceeds. The exchanges are also subject to very strict timelines under which things have to happen, like identifying the property and the sale to be completed.
In addition to this, the investor may not have access to the proceeds of the funds during the entire process. These are extremely important notes. However, if 1031 is executed according to the rules to the letter of the law, this option can allow investors to leverage their earnings more fully without paying taxes at that time.
Moreover, since it’s okay to conduct sequential exchanges, a savvy investor can actually continue deferring the payment of any capital gain taxes semi-indefinitely if they know what they’re doing and if this is done correctly over and over and over again, this might culminate in them eliminating all of the taxes when they then give this property to their heirs. Do you understand the massive benefits of this strategy if adhering exactly to the IRS codes?
The IRS builds these advantages into the system to incentivize you to operate and invest in certain ways. So things like the 1031 exchange advantages are huge because they’re given to us directly from the IRS.
Additionally, using a 1031 exchange also permits the investor to defer payment of any depreciation. Recapture depreciation is an amazing tax deduction and it allows taxpayers to reduce their tax obligations and it allows taxpayers to reduce their obligations that year or subsequent years by recovering the amount spent to buy the asset from the beginning.
For example, commercial properties can be deducted over 27.5 years or 39.5 years depending on the property type. However, if the investor later sells the property at a higher value, they must repay the depreciation deduction that they took. The 1031 exchange defers this recapture as well so they can be used together to maximize your strategy with the IRS’s tax codes. Additionally, there are some newer strategies that are emerging as well.
IV. DEFERRING AND REDUCING CAPITAL GAINS TAXES WITH A QOZ INVESTMENT.
The 2017 Tax Cuts and Jobs Act added another opportunity for investors to manage capital gains obligations. They incur like 1031 exchanges. These investments must be carefully planned to qualify for the benefits. The qualified Opportunity zones or QOZs are geographic areas that the government has designed as needing increased investment from the investment community of real estate investors.
Temporarily investors could eliminate capital gains altogether by investing eligible gains into these qualified opportunity zones and while that provision has already expired, investments in such projects can still earn tax-free profits for investors today.
V. HARVESTING LOSSES
Despite all these tools we’ve outlined so far, taxpayers may sometimes still have gains subject to tax levies, and that’s where the next strategy comes in harvesting your losses. If you do have losses along the way in your investment career, these can be used to offset the gains that you’ve received with that loss that you’ve incurred.
In fact, capital losses that you might incur can even offset ordinary income as well subject to some limits, but it can if done correctly. If you have a loss that’s more than the gain that you need to offset, you can carry that balance forward into a future year. So investors can then use business losses as well as capital losses to reduce their tax obligations.
For example, suppose you operate a business and you incur losses along the way. In that case, you can roll the excess loss forward to another year. When you have a higher taxable income, typically you cannot do the same with ordinary income, which highlights another advantage for the wealthy that they regularly implement in their tax strategies.
Speaking of the wealthy, doing things differently, what do they do when they’re ready to get some money out of their assets? Well, most people sell their assets when they’re ready to get some money out of but the next strategy is not about selling.
VI. DON’T SELL; BORROW
If you’re an investor and you want money out of your assets, you don’t actually have to sell, in which case you’d incur the taxes associated. Instead, do what the wealthy do. Wealthy people can borrow against their assets and their portfolios.
This asset-based lending is not considered income because it’s not income, so it’s also not taxable and since the lender can collect the assets that back to the loan, and in the event, the investor does not pay that loan, the investor will likely get more favorable terms than others who take out a personal loan without the collateral of assets. The interest is typically far less than the cost of paying taxes on liquidated assets, and you have the advantage of still owning the asset in question. The strategy is so misunderstood. The fact is that there are many strategic uses for debt, and the biggest question is whether the debt that you’re taking on in day-to-day investing and in life is good debt or if it’s bad debt. Wealthy people use debt as an entire strategy on their own.
So to outline some of the most strategic ways that you can use debt to your advantage, we have an entire video outlining how billionaires use debt to grow their net worth consistently. We looked into how the world’s wealthiest people use debt to make even more money along the way, strategically.
President of Saint Investment Group
Nic is a two decade seasoned expert in investing and capital raising, specializing in Real Estate and debt markets. With Saint Investment Group, he leads large-scale distressed asset purchases and innovative syndications for investors.