Tax Tricks and Loopholes Only the Rich Know
You probably remember this: Before the 2020 presidential election, The New York Times released a bombshell report on Donald Trump's tax records -- claiming that he paid no federal income taxes in 11 of the past 18 years. According to the report, he did pay income taxes in 2016 and 2017 -- in the amount of $750 each year.
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Trump questioned the accuracy of the Times report in a Sept. 28, 2020, tweet: "I paid many millions of dollars in taxes but was entitled, like everyone else, to depreciation & tax credits."
In 2021, nonprofit newsroom ProPublica stacked more evidence against America's wealthy elite, revealing that between 2014 and 2018, the United States' 25 wealthiest individuals got $401 billion richer -- but the income taxes they paid covered only 3.4% of their new net worth.
Trump and many other wealthy individuals have taken advantage of some of the tax loopholes that can reduce their yearly tax burden. Find out what you might be able to write off to save more.
1. Claim Depreciation
In his tweet, Trump calls out depreciation as a means of reducing his tax burden. So what exactly is it?
"For federal income tax purposes, depreciation is a deduction that allows you to recover the cost or other basis of certain property," tax expert Kelly Phillips Erb wrote in a post for Forbes. "It can be tricky but generally, you begin to depreciate your property when you place it in service for the first time. The IRS considers property 'placed in service' when it is ready and available for use, not when you actually begin using it. You depreciate the cost of the item over its useful life (based on the kind of property) unless an exception applies."
How To Get the Deduction
Depreciation can be claimed for both tangible and intangible property. Property that may be eligible for this deduction includes buildings, rental properties, machines, cars and trucks, furnishings, equipment, patents, copyrights and some kinds of software, according to TaxGirl.com. To qualify for the deduction, the property must meet three requirements:
It's used for a business or income-producing activity.
You own the property.
It has a determinable "useful life" of more than one year.
Depreciation claims are made in section 179 of your federal tax returns. For the tax year 2020, the maximum expense deduction was $1,040,000. In 2022, it stood at $1,150,000.
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2. Deduct Business Expenses
If you run a business, you might reap big tax benefits. Business owners who are filing taxes can claim potential tax deductions for some business expenses, including those tied to:
Travel
Vehicle
Office supplies
Work-related education expenses
A home office
Not every venture qualifies as a business entitled to such tax write-offs, however. To qualify, you must intend to try to make a profit in your business rather than engaging in what the IRS considers to be merely a "hobby."
However, sometimes the lines are blurred between business and personal expenses. For example, Trump has claimed residences, aircraft and $70,000 in hairstyling for television as business expenses on his tax returns, according to The New York Times. Among these residences is his family's Seven Springs estate in Westchester County, New York, which Trump has classified as an investment property, enabling him to write off $2.2 million in property taxes since 2014.
How To Get the Deduction
How do you distinguish between a hobby that produces some income and a bona fide business? The IRS considers many factors that can be found on the organization's website. A few of them include:
Whether you carry on the activity in a businesslike manner
Whether the time and effort you put into the activity indicate you intend to make it profitable
Whether you depend on income from the activity for your livelihood
3. Hire Your Kids
Business owners who turn their venture into a "family affair" can put more money back into their pockets. For example, hiring your kids offers potential tax benefits.
According to the IRS: "Payments for the services of a child under age 18 who works for his or her parent in a trade or business are not subject to Social Security and Medicare taxes if the trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child."
It can also help lower taxable profits. For example, Trump hired an unnamed consultant to aid with hotel projects in Hawaii and Vancouver, British Columbia. The amount paid to this consultant was identical to a payment Ivanka Trump received through her consulting company that year, The New York Times reported. These consulting fees reduced Trump's taxes because he was able to write them off as a business expense, lowering the amount of the final profit subject to tax.
How To Get the Deduction
Instead of paying high taxes on your business income, transfer some of that income to your child as wages for services they perform. Your child's work must be "legitimate," however, and the salary must be "reasonable," said Gail Rosen, a Martinsville, New Jersey-based certified public accountant.
4. Roll Forward Business Losses
Trump claimed a total of $1.4 billion in losses from his core businesses for 2008 and 2009, The New York Times reported. By rolling forward these losses, Trump was able to later claim a $72.9 million tax refund. How exactly this all works is a little complicated.
"Business losses are sometimes called net operating losses (NOL)," Phillips Erb wrote in the Forbes post. "An NOL generally results when your tax deductions exceed your taxable income. If that number is negative in one year -- but has been positive in other years resulting in tax payable -- that doesn't quite seem fair. The NOL exists so that you can balance that inequity. In other words, you can use the loss in one year to lower your taxable income and reduce your tax burden in another year."
How To Get the Deduction
"Under existing tax laws, if you have an NOL, you first carry back the entire NOL amount for a number of years and if you still have an NOL remaining after you carry those losses back, you can carry the losses forward," Phillips Erb wrote. "You can also opt not to carry back an NOL and only carry it forward for up to 20 years. A carry forward means that you can apply the loss towards your income in a future year."
Trump was able to carry his losses back four years, which allowed him to recover taxes he paid when his business ventures -- including "The Apprentice" -- were profitable.
"By piling on losses (the legitimacy of which may be in question), he was able to generate a tax refund of $72.9 million (tax paid for 2005 through 2008, plus interest)," Phillips Erb explained.
5. Earn Income From Investments, Not Your Job
Instead of working for their money, wealthy people can make their money work for them, said Pompano Beach, Florida-based accountant Eric J. Nisall, founder of AccountLancer, which specializes in accounting for freelancers.
Investments that offer distributions such as real estate investment trusts (REITs) and master limited partnerships (MLPs) are set up in ways that can bring in a steady generated income. Invest in stocks or invest in real estate by purchasing rental properties. Remember you'll have to make significant upfront investments before you start seeing returns.
How To Get the Deduction
The tax on earned income can be as high as 37%. Invest in high-yielding dividend stocks and collect dividends that the companies pay at regular intervals. Later, you can sell the stock after it has appreciated and pay a relatively low capital gains tax rate. Depending on how much was earned in a particular year, long-term capital gains tax rates are 0%, 15% and 20% for 2022.
If you own property that you rent out as a landlord, you'll be able to deduct your property taxes. Remember, though, you have to find tenants who will pay the rent on time and won't trash your property. Urgent repairs and periodic improvements can be costly, as well.
6. Sell Real Estate You Inherit
If you inherit a piece of property, you can minimize the capital gains taxes by taking advantage of the "step-up in basis." Normally, if you buy a piece of land for $200,000 and then sell that land for $450,000, you'll owe tax on that $250,000 gain. However, if your parents purchase the land for $200,000 and you inherit it, your new basis will be the fair market value of the property at the time you inherit it. If you sell it immediately, you won't owe any tax at all on that $250,000 gain.
How To Get the Deduction
The stepped-up basis is an automatic process that happens to all property that passes by way of inheritance. For tax purposes, it's like you're starting over, purchasing the property anew at the current price.
In the previous example, if you inherit the property from your parents when they die, you won't be liable to pay capital gains tax on the $250,000 increase in the property's value when you sell it using the step-up basis. Make sure your parents don't give the property to you before they die, however. If they do, they'll owe hefty taxes during their lifetime, and any financial benefit to you will be vastly diminished.
7. Buy Whole Life Insurance
You ordinarily associate life insurance policies with the need to provide for your dependents if you die. A secret strategy that the wealthy take advantage of is buying whole life insurance, however. It's a combination of an insurance policy and an investment account.
How To Get the Deduction
You can receive tax-deferred growth as your policy grows. It's also possible to receive tax-free distributions under certain conditions.
The double benefit is that the wealthy policy owner gets this tax break during their lifetime. After their death, the amount of the policy benefit goes directly to the lucky beneficiary they named, who receives it tax-free.
Consult a qualified and experienced financial planner or insurance agent. Also, consult an expert to find out if whole life insurance is right for you. Some experts believe it's a bad investment, partly because of the expensive fees.
8. Buy a Yacht or Second Home
Most Americans don't have the cash to buy a boat or a second home. But having multiple residences can lessen a rich person's tax bill.
How To Get the Deduction
If you own a home and itemize your deductions on your tax return, you can usually deduct the property taxes and the interest you pay on the mortgage -- though there is an upper limit of $10,000 that taxpayers are allowed to deduct for property taxes. If you buy a second home, you can deduct the taxes and mortgage interest on that property, as well.
The IRS notes that a yacht can qualify as a home, provided it includes sleeping quarters, a kitchen and a toilet. This strategy probably isn't practical for those who can't afford a second home -- particularly an expensive one that floats. But even if you own just one home, you should learn about the tax breaks for homeowners.
9. Open an HSA
A health savings account is a tax-deferred account that was originally designed for healthcare expenses. However, when used properly, the account can become triple tax-free.
For starters, contributions to an HSA are tax-deductible, even if you don't itemize deductions. Next, earnings in the account grow tax-free.
Finally, distributions are tax-free if they are used for qualifying healthcare expenses, according to the same requirements as deductible medical and dental expenses on Schedule A. Distributions for nonhealthcare expenses generally trigger a 20% penalty.
There's one additional kicker that the rich and tax-savvy can also use to their advantage: After you turn age 65, you can withdraw your HSA money for any purpose at all without penalty, although you'll still owe ordinary income tax if you spend the money on nonhealth expenses.
How To Get the Deduction
You can get the HSA deduction by opening an HSA and making contributions. HSAs are not available to all taxpayers; you must participate in a high-deductible medical insurance plan. Contributions are limited to $3,650 for individuals in the tax year 2022, or $7,300 for family coverage.
Report your HSA contributions, calculate your deduction, report distributions and figure your HSA taxes and penalties on Form 8889.
10. Open a Solo 401(k) Plan
Most employees for larger corporations have heard of a 401(k) plan, which allows for tax-deductible contributions and tax-deferred growth of investment earnings. Those who contribute may be familiar with the annual contribution limit, which is $20,500 for the tax year 2022.
If you work for yourself, you may think that you're out of luck when it comes to contributing to a 401(k). The truth is if you're self-employed, you should consider it a stroke of good fortune. Individuals can open up their own solo 401(k) plans, and they can also contribute up to a whopping $61,000.
How To Get the Deduction
You'll have to set up a solo 401(k) plan at a bank or brokerage account to get started. When you file your taxes, submit IRS Form 5500 to report your contributions.
11. Defer Income
You only pay taxes on the amount of income that you receive in any given year. Even if you complete work and are entitled to payment, if you don't actually receive the payment until the following year, you won't owe taxes on it until then. Thus, if you can defer receiving income even a single day, from Dec. 31 until Jan. 1 of the following year, you can wait another full year before you have to pay tax on it.
How To Get the Deduction
This is probably the easiest "deduction" of all to claim. When you defer income into a future year, you simply don't include it in a given year's income tax filing.
For example, if you're due a bonus on Dec. 31 but ask your employer to pay it on Jan. 1 instead, you simply include that income on your following year's tax return.
12. Harvest Tax Losses
U.S tax law states that you have to pay capital gains tax on profits you take in taxable accounts. Worse still, if your gains are short-term in nature, meaning you held them for one year or less, you'll have to pay tax at your ordinary income tax rate. If you're in the top federal tax bracket, that means you'll owe 37% in federal tax alone on your short-term gains, according to the standards from the tax year 2022.
The smart way around this short-term gains tax is to harvest your capital losses to offset those gains.
How To Get the Deduction
If you have any investments trading at a loss, you can sell them, realize those losses and use them to offset your capital gains. If your losses exceed your gains, you can even write off up to $3,000 of ordinary income using those losses. In this way, a paper loss on security can translate into thousands of dollars in tax savings if you use it to offset your gains.
You'll have to report your capital transactions on Form 8949 before summarizing your capital gains and deductible losses on Schedule D.
The wealthy might try to keep these and other tax strategies as their secrets. But, if used correctly, these tax breaks and tax loopholes can benefit everyone else in cutting state and federal taxes.
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Gabrielle Olya contributed to the reporting for this article.
This article originally appeared on GOBankingRates.com: Tax Tricks and Loopholes Only the Rich Know
