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Tax Favored Income Legal Tax Angles: How to Save Taxes Without Going to Jail The U.S. tax law discriminates in favor of some kinds of income and imposes a higher tax burden on other income. For those who wish to find ways to reduce their tax burden, the following types of income would be a good place to start. The following descriptions are a non-technical and very abbreviated explanation of various tax law provisions that require many pages of fine print to cover completely. Consider the following comments to be no more than a check-list of opportunities to consider for further evaluation. Long Term Capital Gains The Tax Relief Act of 2003 reduced the top federal tax rate on certain long term capital gains to just 15%. Taxpayers whose other income is subject to a 15% or lower tax rate may be eligible for a 5% rate on capital gains or even a zero rate on such gains. A portion of the gain on depreciable real estate may be subject to a 28% tax rate on capital gains and the rate on certain kinds of assets known as "collectibles" (also known as hard assets) is 25%. Such gains are not subject to the self employment tax but might be subject to estate or gift taxes in some cases. Entire books have been written to explain the details about capital gains and the kinds of assets that can generate such tax favored gains. Generally, most kinds of investments that appreciate in value (such as stocks) will qualify for capital gains treatment when sold. Gains on the sale of bonds will also qualify but with important and technical exceptions. Real estate gains may be eligible for the 15% rate but some kinds of depreciable real estate is subject to a 28% rate on gains attributable to previous depreciation deductions. As a general rule, most kinds of assets will gain in dollar value as a result of inflation. Some stocks gain in value because the company is making a profit and re-investing that profit for increased growth and future profits. Bonds and other fixed return investments will gain in value as interest rates decline, but will lose value when interest rates increase. However, as noted above, certain kinds of collectible (such as coins, stamps, art, antiques, bullion, etc.) are subject to a 25% federal tax rate on gains. For most kinds of assets, a "long term" gain is a gain from an asset that has been held for more than a year. For further details see my report on the 2003 tax law. Qualified Dividend Income The same 2003 tax law introduced a top tax rate on qualified dividend income to 15% and 5%. With some modest research, it should be much easier to find dividend paying stocks with an attractive yield than to find assets that are likely to increase in value by an equal percentage of your investment. For further details see my report on the 2003 tax law. Profits of Taxable Corporation If the stock of a corporation gains in value over a period of a year (plus one day), the gains will generally be treated as long term gains and will be eligible for the 15% or 5% federal tax rate. This can be accomplished by purchasing the stock of a small business that is experiencing problems but is capable of being rejuvenated or restored. Expertise in the management of a business is the prime requirement to enjoy this kind of tax favored income. For example, if you were to purchase a majority of the stock of a small corporation for $10 a share and you could increase the profits of the company by 30% in two years, your stock would be worth at least 30% more than when you bought it. If part of the money to buy the corporate stock is borrowed, the interest may be deductible as an investment expense -- but the deduction will be limited to the amount of other investment income received. Another way to accomplish similar results is to start a business venture as a taxable corporation and to build it to a point where it would be of interest to outside investors. However, as a general rule, this is far more difficult than turning an unprofitable business into one that is making a profit. Those who do own shares of a profitable small corporation should be able to make distributions that will only be taxed to the owners at a 15% (or 5%) federal tax rate. The bottom federal tax rate for a corporation is is 15% on the first $50,000 of profits. Thus, if the corporation made $50,000 and paid $7,500 in taxes and then distributed the remaining $42,500 as a dividend, the tax on the dividend would be no more than $6,375. That would leave $36,125 after taxes from a total income of $50,000. The combined corporate and personal tax rates would be 27.75%. And if the dividends are distributed to a lower bracket family member, the tax burden could be further reduced. Gift of Gains to Charity You can't really make a profit by making gifts to charity, but if you are going to support a charity, university or church anyway, you can save some taxes by giving the charity some appreciated assets. The reason is because you get to deduct the fair market value of the asset given to the charity and don't have to pay any tax on the unrealized gain. For those who are selling the stock of a successful family business, there may be some advantages in gifting part of the stock to a charitable remainder trust. The trust can sell the stock without paying a capital gains tax and can invest 100% of the proceeds to earn income that can later be distributed to the taxpayer as a tax deferred retirement income. Inflationary Gains It's been a few years since we have seen any substantial inflation, but some economic and investment experts are warning that much higher rates of inflation are likely if the government continues to create new money through the issuance of new government debt obligations to the Federal Reserve. As a general rule, most kinds of hard assets (like land, collectibles, oil and gas interests, timber and other tangible assets) will gain in value to keep pace with inflation. Although interest rates will generally rise to compensate the lenders for the expected loss of purchasing power because of inflation, there may be some opportunities to leverage the ownership of inflation sensitive investments with borrowed funds. The "trick" is to find a way to pay a lower rate of interest on the borrowed money than the rate of inflation or gain on the hard assets you buy. With some types of inflation resistant assets (like real estate), income from the asset will help to offset the cost of the interest to leverage the gains. Investment Interest Expense The tax law allows investors to deduct the cost of interest on loans when the proceeds are used to buy or to hold investments. However, the law does not require a direct matching of the borrowed funds and the purchase of investments. Instead, the interest on the debt is deductible to the extent of any otherwise taxable investment income. Where the income is subject to reduced tax rates (like capital gains and dividends), the calculations will get a bit complicated and I won't even attempt to offer any kind of example. But if a taxpayer borrows $100,000 to buy $200,000 of heavily discounted bonds (due to reasons other than a discount at the date of issue), the interest on the loan is deductible to the extent of the interest received on the bonds, plus any other taxable investment income. The trick to using this tax break is that the taxpayer needs to have some substantial expertise in the asset that is being bought with borrowed funds. Leveraged Real Estate The use of borrowed funds to purchase real estate is so common it is often assumed to be unavoidable. Assume you buy a property for $250,000 and you borrow $200,000 from a bank to make the purchase. The tax laws offer a number of incentives for real estate owners to make maximum use of borrowed funds. First, the entire value of the property (excluding land) can be depreciated -- which is tax deduction that doesn't require an equal cash outlay. (On the other hand, the loan payments of principal are not deductible.) If the depreciation deduction averages 4% a year, the loan generates five times as much depreciation. Second, the interest on the loan is deductible even when there is no offsetting investment income. If a run down property is purchased and restored so that it is more profitable, the owner can often do a tax deferred exchange of the restored property for another run-down property. Over a period of a few years, an astute real estate operator can parlay a small cash investment into a very large real estate operation. Loan Proceeds The tax law does not generally treat loans as income. The reason is because the loan has to be repaid at some future date. Roth IRA Distributions
Vacation Home Income
Depreciation Conversion
Sale of Stock in Family Business
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Books and Services by Vern Jacobs
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