Play by Tax Rules of the Rich
Most of us know taxes are our greatest expense. Yet most people choose to ignore the subject of tax. They choose to be ignorant, then get angry at people like Donald Trump who know how to make money and pay less in taxes — legally.
Many of these people vote for politicians who promise to “tax the rich.” Then they wonder why their taxes keep going up.
The problem is not taxes; the problem is spending.
One of the reasons for wealth and income inequality is tax. Simply stated, the rich know how to make more money and pay less in taxes than the poor and middle class — legally. The rich are not always smarter, they simply prefer not to be ignorant.
There are more taxes than just income tax. There are taxes on taxes. It is estimated that for every dollar a person spends, 80% goes directly or indirectly to some kind of tax and back to the government.
For example, if you pay a dollar for gasoline, not only is your dollar net after-tax, which means your dollar has already been taxed, most of the money you pay for the gasoline is going to other levels of tax. The oil company receives very little of the dollar you used to purchase your gasoline. Then the oil company pays taxes on the tiny bit of your dollar they receive.
Talk about pennies on the dollar!
The lack of financial education shows up in our political leaders. Most are employees, like my poor dad. They’re people who know how to spend money but have no idea how to make money. Financially ignorant leaders are at the core of this global crisis.
Two Tax Mindsets
If you earn your money as an employee, as opposed to an investor or business owner, it’s likely you have a different mindset about taxes.
For example, people who are employees or self-employed respond to the incentive of more money, more income, higher pay, and bonuses.
As a result, you pay higher taxes.
Business owners and investors, on the other hand, work for tax incentives. They make more money, indirectly, via tax breaks.
Business owners receive tax breaks for hiring employees. The government does this because the government needs jobs for people. There’s a steady stream of tax dollars flowing into government coffers from employee paychecks. So the government offers the incentive of lower taxes.
These are entrepreneurs such as Elon Musk. He receives billions in tax breaks from different states and from the U.S. government.
Investors, meanwhile, receive tax breaks for investing in things sucha s apartment complexes. If I didn’t provide housing, the government would have to, costing taxpayers a lot of money. So rather than ask taxpayers to pay higher taxes, the government offers entrepreneurs like me tax incentives.
I become a partner with the government.
Play 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, Arizona. The developer paid us $20,000 a year to use these 10 units as sales models. So, we received a 20% 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 which 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.
Real estate: the best way to take advantage of the tax code
One of the most powerful (and my favorite) ways of using taxes to get richer is through real estate. Let’s examine some of the other ways investing in real estate can help reduce your taxable income:
- Deductions – Did you know that you can deduct certain rental expenses — such as mortgage interest, property tax, operating expenses, depreciation, and repairs — from your tax return? Make sure to keep track of deductible expenses, such as receipts, in case you are audited. Also, keep track of any travel expenses you incur for rental property repairs. The IRS is a great place to read more about real estate deductions.
- Pass-through entities – Thanks to the Tax Cuts and Jobs Act of 2017 (TCJA), residential landlords who operate as pass-through entities (a special business structure, such as sole proprietors, LLCs, and S corps, that eliminates the burden of double taxation) can now deduct 20% of net rental income right off the top. Yes, you read that right: this essentially makes 20 of your profits tax-free. There are some limitations and exceptions, so be sure to consult your tax advisor before assuming you qualify.
- 100% bonus depreciation – Before the tax changes, business owners were eligible to deduct up to half of the cost of assets that they purchased for their business in one year — now landlords can deduct 100% of the personal property for rental units. This law changes again in 2023, so now is the time to take advantage. These rental unit improvements could include appliances, a new roof, upgraded HVAC systems, fire protection and alarm systems, and even furniture.
- Low-income housing tax credits – The Low Income Housing Tax Credit program provides tax incentives to encourage developers to create affordable housing. As an incentive to make equity investments in affordable rental housing, private investors receive a federal income tax credit.
- Historic building tax credit – There’s a federal tax credit for investors who rehabilitate qualifying historic buildings — they can claim 20% of eligible improvement expenses against their federal tax liability. Note: With the new TCJA, taxpayers must now take this credit over five years instead of in the year they placed the building into service.
Play it smart,
Editor, Rich Dad Poor Dad Daily