2 Easy Strategies To Use To Pay Less Taxes
Today I am going to begin my two part series on taxes. I hope you enjoy!
In the big picture of personal finance, there are four financial forces that cause most people to work hard and yet struggle financially. They are:
Take a moment and reflect briefly on how much these four forces affect you personally. For example, how much do you pay in taxes? Not only do we pay income tax, but also sales taxes, gasoline taxes, real estate taxes, and so forth. More important, to whom do our tax dollars go and for what causes?
Many years ago, I was asked by a newspaper reporter how much money I’d made in the last year. I told him that I made about a million dollars that year.
The reporter’s follow-up question was, “How much did you pay in taxes?”
To his surprise, I said that I paid nothing.
“How could that be?” he asked.
I then went on to explain that I had sold three pieces of property and was able to defer my income by placing the proceeds into a 1031 exchange. The money was never technically income but instead reinvested into new, larger properties.
Later, when the reporter published his article, the headline read, “Rich Man Makes $1 Million and Admits to Paying Nothing in Taxes.” While he had the facts right—I did pay nothing in taxes—he got the spirit all wrong.
The reality is that the IRS tax code is written to encourage and reward certain types of behaviors.
At a high level, the IRS wants people doing activities that spur growth and that provide jobs. Thus, they have many tax breaks for entrepreneurs and investors.
On the other hand, the IRS has little value for people who make a lot of money but don’t create anything for the economy in terms of growth or jobs.
So, it is not surprising that the top 1% of earners pay the largest share of taxes rather than the top 0.01%.
Because most of those in the top 1% are not entrepreneurs or investors. They are high-paid employees who earn the highest-taxed type of income: earned income.
The ultra-rich, on the other hand, are those whose wealth is often built on starting a company or investing professionally. These activities are rewarded by the IRS and so they have many more tax breaks than even those making hundreds of thousands of dollars a year. The ultra-rich know how to limit their earned income and instead make most of their money via passive income vehicles like their companies and investments. Thus, they pay a substantially lower tax percentage than high-income earners.
High-income employees, and the ultra-rich is the mindset. And the good news is that you can start thinking like the ultra-rich when it comes to taxes and money, and your wealth will grow.
First, stop looking for a high-paying job and start thinking about how you can create them instead. The IRS will reward you if you take entrepreneurial risks.
Second, invest your earned income into assets that produce passive income via cash flow every month. The IRS will also reward you for that. By this, I do not mean your 401(k), which is taxed at an earned income level. You have to find true assets like rental properties, businesses, and commodities that are taxed at the passive income level.
You do not have to start big. Just do what you can and continue to build into larger and larger opportunities. The most important thing is to think like the ultra-rich, not like an employee.
At the end of the day, there are two groups who pay the least in taxes: the poor and the ultra-rich. If you don’t want to pay taxes, but you’re also not interested in being an entrepreneur or an investor, then your only choice is to become poor.
Playing by the Rules of the Rich
There are many ways that the rich make a lot of money and pay little to no money in taxes, and anyone can use them. As an illustration, here’s a real-life situation in which I played by the rules of the rich and minimized my taxes:
- My wife, Kim, and I put $100,000 down to purchase 10 condominiums in Scottsdale, Ariz. The developer paid us $20,000 a year to use these 10 units as sales models. So, we received a 20 percent cash-on-cash return, on which we paid very little in taxes because the income was offset by the depreciation of the building and the furniture used in the models. It looked like we were losing money when we were, in fact, making money.
- Since the real estate market was so hot, the 380-unit condo project sold out early. Our 10 models were the last to go. We made approximately $100,000 in capital gains per unit. We put the $1 million ($100,000 x 10 units) into a 1031 tax-deferred exchange. We legally paid no taxes on our million dollars of capital gains.
- With that money, we purchased a 350-unit apartment house in Tucson, Ariz. The building was poorly managed and filled with bad tenants who had driven out the good tenants. It also needed repairs. We took out a construction loan and shut the building down, which moved the bad tenants out. Once the rehab was complete, we moved good tenants in and raised the rents.
- With the increased rents, the property was reappraised and we borrowed against our equity, which was about $1.2 million tax-free because it was a loan—a loan that our new tenants pay for. Even with the loan, the property still pays us approximately $100,000 a year in positive cash flow.
- Kim and I then invested the $1.2 million in another 350-unit apartment house in Flagstaff, Ariz., a hot property market, all tax-free.
Move Money, Don’t Park It
This is an example of an investment strategy known as the velocity of money. As I’ve written before, moving your money makes more sense than parking it in cash, bonds, equities, or mutual funds—the strategy most financial advisors recommend.
Kim and I have several such scenarios active at any one time. We have lots of monthly cash flow, which we reinvest, but we rarely have any liquid cash sitting around to be taxed.
In the above example, we started with $100,000 we earned tax-deferred from another investment. The $100,000 eventually allowed us to borrow over $20 million from banks, tax-free. How long would it take you to save $20 million by parking your money somewhere, as most financial advisors recommend
Chipping Away at Taxes
Clearly, one of the reasons the rich get richer is because they earn a lot of money without paying much, if anything, in taxes. They know how to use banks’ tax-free money to become richer.
Anyone can do the same. For instance, instead of paying capital gains tax on the sale of our condo units, real estate laws allowed us to defer paying these taxes and invest them into another property instead. The cash that does come from this property goes into our pockets at a lower tax rate because there’s no Social Security or self-employment tax to pay, and the tax rate is further reduced by the depreciation of the property.
On the flip side, the poor and middle-class toil away for their money, pay more in taxes the more they earn, and then park their earnings in savings and/or retirement accounts. In the meantime, they receive little or no cash flow on which to live while waiting for retirement—when they’ll live on their meager savings.
But if you want to be financially free and pay little-to-nothing in taxes, you’ll need to choose the path of the ultra-rich. Speaking as one who has walked that path, it is one of the most rewarding journeys you can take. Because at the end of the day, it’s not about how much money you make, but how much money you keep.
Editor, Rich Dad Poor Dad Daily