How to Pay 0 Taxes Partnering with the Government
During the last U.S. presidential election, President Trump got hammered in the media for paying only $750 in taxes.
The criticism of Trump in the media and by his opponents only serves to show their ignorance when it comes to money and taxes and debt.
The other part of the news story is how much debt Trump has, but as he points out, if you look at his assets, he is underleveraged.
I love real estate, and so does Trump. Why? Because of debt and taxes.
You can purchase more assets for your dollar with debt. And you can save more in taxes through the tax code with credits and depreciation. It’s basic investing, but unfortunately, most people know nothing when it comes to money, taxes, and investing. So they howl and moan, showing they’re the highest-educated idiots in the room.
I bet a lot of people would agree with me if I said that the two nastiest words in the world’s financial vocabulary are debt and taxes. Debt and taxes are the real reason for the growing gap between the rich and everyone else.
That is why 1913 is a critical year in world history. In 1913, the U.S. Federal Reserve Bank was created. It was also the year the 16th amendment was ratified, the action that led to the creation of the Internal Revenue Service—the dreaded, and often feared U.S. tax department.
Today, debt and taxes are like cancer, eating away at the heart and soul of the poor and middle class. The U.S. national debt is a disaster waiting to happen. Yet, on the other side of the coin, debt and taxes continue to make the rich richer.
Debt & Taxes
How can a person know what they are doing if they know so little about debt and taxes?
Whenever I say, “I make millions and pay very little taxes—legally,” most people’s hearts go into cardiac arrest and their minds slam shut. I doubt there are many people more feared than the taxman. Few things are more painful than a government tax audit. Yet it does not have to be that way, if—as Buffett states—“you know what you are doing.”
Having Tom Wheelwright as my mentor, teacher, and tax advisor gives me tremendous confidence to do what I do daily as an entrepreneur and professional investor.
Before I do anything that could cross the line, I check in with Tom. Life is so much easier if you follow the rules, especially the tax rules and laws.
As Tom always says, “The tax rules are primarily incentives, government guidelines on how to be a partner with the government, doing what the government wants and needs to be done.” That is why tax laws throughout the world favor entrepreneurs and big businesses.
Today, Kim and I are real entrepreneurs.
We do not work for money, we create assets, create jobs, and play Monopoly in real life. And we partner with the government doing what the government wants to be done and, in exchange, the government gives us tax incentives to be good partners.
This is why real financial education must start with debt and taxes.
Real financial education must look at the other side of the coin of debt and taxes.
Real financial education must teach the student how debt and taxes make the rich richer.
Real Financial education must also teach the student how debt and taxes can make them richer too.
Four profit centers of real estate
Real estate profit center #1: Cash flow on operations
As the name implies, this is the cash flow profit center of real estate.
If you’re holding real estate as an investment, you will have tenants. Each month they will pay you rent. Let’s say that you own a rental house and get $1,000 per month in rent. Over a year, that is $12,000 in income.
Now, subtract out your expenses, which include things like your taxes, insurance, your property management, vacancies, turnover expense, allowances for repairs, etc. (This doesn’t include your debt—more on that later).
For purposes of this example, let’s assume that your monthly average expenses are $100 a month. Your cash flow on operations would be $900 per month. That is what is referred to as your Net Operating Income (NOI).
Out of your NOI, you pay your debt service. Let’s assume for this example that you have a $200,000 property with a $180,000 loan at a rate of 3.7%. That’s a debt payment of about $830 a month.
So, that would be the rental income of $1,000 minus $100 in operating expenses minus $830 in debt service, equaling $70 in cash flow. That times 12 equals $840 in cash flow per year. That $840 divided by your $20,000 equity stake would equal a 4.2% cash-on-cash return.
But that’s not the end of your real estate profit story. Let’s move on to the next profit center: Amortization.
Real estate profit center #2: Amortization
Amortization is the concept of paying down your debt service. It is phantom income because you don’t get the money in your pocket each month, but your equity grows with each payment you make—and because your rental income covers the debt payment, it is income to you. Let me explain further.
Each month, when you make your debt payment (or rather your tenant makes your debt payment) out of your NOI, a portion of that goes towards paying down your principal on the loan. When you hear somebody talk about a 30-year fixed fully amortized loan, it means that when you make all 360 of those monthly payments at the end, the loan is 100% paid off.
Because your tenant is paying rent, and that rent is covering the debt payment, the principal pay down included in that debt payment is profit for you. Let’s take a look at how this plays out with our $180,000 loan from above.
In the first year of the loan, you’d be paying $6,604 in interest and $3,338 in principle. As the loan matures, the interest amount goes down each month and the principal amount goes up. But we’ll use these numbers for now.
That $3,338 is profit to you. It’s true equity in your property.
If we add this $3,338 to the $840 in operating income, we now have $4,178 in income for the year, a 20% return on our $20,000 invested into the property. Plus, your interest payment is often tax-deductible, it’s an added bonus but check with your tax advisor to be sure for your specific case.
Already, you’re crushing average stock market returns and there are still two more real estate profit centers to look at.
Real estate profit center #3: Depreciation
Depreciation is another form of phantom income, but it is also often referred to as a phantom return. The basic concept of depreciation is that your investment property is made up of two parts, the land and the improvements on the land, i.e., your house.
Appraisers will assign percentage values to your property based on these two parts. For this example, 20% of the value is the land and 80% of the value is the improvement. Over time, the house will deteriorate, so the government in the US (check with your tax advisor to make sure you qualify), lets you write down that 80% value over a certain number of years depending on the type of real estate. For residential homes, it’s 27.5 years.
So, your $200,000 property has $160,000 that can be depreciated over 27.5 years, which equals $5,818 per year. This amount is listed as a loss of income, even though no money is coming out of your pocket. Now, let’s see why this is called phantom income.
Let’s assume you are in a 30% tax bracket. That means that applying 30% to your depreciation of $5,818, nets you $1,745 in annual tax savings.
Adding that $1,745 to our existing income of $4,178, we now have $5,923, a 29.6% return on your cash of $20,000.
Let’s take a look at the last profit center, appreciation.
Real estate profit center #4: Appreciation
Appreciation is the phantom income frosting on your cake. I don’t invest in real estate for appreciation. I’m a cash flow investor. But I do appreciate my appreciation, pun intended.
Let’s assume you have a conservative appreciation rate of 3% a year on average for your $200,000 property. That equals $6,000 per year in value-added to your house.
Add that to your $5,923 and you have $11,923. That’s a 59% return on your $20,000 capital investment in your $200,000 property. And that blows investing in the stock market for the long term out of the water.
These types of returns are achievable by anyone, as long as they understand how to find the right deal and run the numbers correctly. And it takes a high financial IQ.
Editor, Rich Dad Poor Dad Daily