You work hard for your money but, unfortunately, Uncle Sam takes a bite out of every paycheck for income and other taxes. And if you’re in the middle class, you probably think that bite is a little bit too big.
According to a 2015 Gallup poll, nearly half of Americans — 46 percent — believe the middle class pays too much in taxes. Yet, some of the wealthiest people find crafty ways to minimize their obligations. Here are seven secret tax strategies the rich use that you can steal to legally decrease your tax bill.
1. Deducting Taxes for Business Expenses
If you run a business, you might reap enormous tax benefits. Business owners can claim potential tax deductions for some business expenses incurred for vehicles, meals, travel, office supplies, advertising, courses and a home office.
However, not every venture will qualify as a business that entitles you to these tax write-offs. You must intend to try to make a profit and not engage in what the IRS considers merely a “hobby.”
How do you distinguish between a hobby — an activity that produces some income — and a bona fide business? The IRS considers these factors, which can also be found on the IRS website:
- 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.
- Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
- Whether you change your methods of operation in an attempt to improve profitability.
- Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
- Whether you were successful in making a profit in similar activities in the past.
- Whether the activity makes a profit in some years and how much profit it makes.
- Whether you can expect to make a future profit from the appreciation of the assets used in the activity.
2. Hiring Your Kids
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.”
Instead of paying high taxes on your business income, you can transfer some of that income to Junior as wages for services her or she performs. However, your child’s work must be “legitimate,” and their salary must be “reasonable,” said Gail Rosen, a certified public accountant. who gave this example of how this strategy works:
“Suppose a business owner operating as a sole proprietor in the 39.6 percent tax bracket hires his 17-year-old daughter to help with office work full time over the summer and part time into the fall. She earns $6,100 with no other earnings. The business owner saves $2,415 in income taxes at no tax cost to his daughter, who can use her $6,300 standard deduction (for 2015) to completely shelter her earnings.”
Brian Vosberg, a certified financial planner (CFP) with Vosberg & Associates in Glendora, Calif., and an enrolled agent with the IRS, said that you might also be exempt from paying self-employment taxes for Social Security and Medicare in respect of your employed children. Otherwise, if they were adult employees, you would owe these taxes on their salaries.
3. Earning Income From Your Investments, Not Your Job
Accountant Eric J. Nisall, founder of AccountLancer, said that the wealthy can make their money work for them, rather than working for their money.
The tax on earned income can be as high as 39.6 percent, which means that people in the highest tax bracket take home only about 60 percent of their gross income.
But, Nisall pointed out that anyone can invest in high-yielding dividend stocks. You collect the dividends that the companies pay at regular intervals and later sell the appreciated stocks. Your benefit is that the tax rate on long-term capital gains resulting from these sales is only 20 percent. This means you pay a smaller amount of taxes for long-term capital gains than the high taxes you pay for income you earn slaving away at your salaried job.
Another option to earn money from investments is to invest in real estate for rental properties. But make no mistake: This process is not easy. Long before you become a landlord and rake in rent money, you have to make a substantial up-front financial investment to acquire the properties and fix them up if necessary. Also, picking lucrative properties in the right locations can be risky. You have to find tenants who will pay the rent on time and won’t trash your place. Urgent repairs and periodic improvements can be costly as well.
4. Selling Real Estate You Inherit
If you inherit a piece of property that’s worth more at the time of the owner’s death than when they bought it, it might minimize the capital gains taxes you have to pay when you sell it. This is referred to as taking advantage of the “step-up in basis” or “stepped-up basis.”
Scott Goble, CPA and financial planner at Sound Accounting, PLLC, explained how it works:
“Let’s say that someone purchases a piece of rental property for $200,000 — excluding the value of the land — and holds that property for 30 years. Over the 30-year holding period, the rental property owner will have received a non-cash depreciation deduction of $200,000, thus sheltering that amount of income.
Let’s further assume that the fair market value of the rental property doubles to $400,000 over the holding period. When the property owner dies, his or her spouse, — or another beneficiary — will receive a stepped-up basis in the property. Thus, the beneficiary can sell the property for $400,000, the fair market value as of the date of the grantor’s death, and pay no income taxes on the gain.”
In the example above, if you inherit the property when your parents passed away, you won’t be liable to pay capital gains tax on the $200,000 increase in the property’s value when you sell it.
However, make sure your parents don’t give the property to you before they die, or else they’ll owe hefty taxes during their lifetime and any financial benefit to you will be vastly diminished.
5. Buying Whole Life Insurance
You ordinarily associate life insurance policies with the need to provide for your dependents should you die. However, a secret strategy that the wealthy take advantage of is buying whole life insurance. It’s a combination of an insurance policy and an investment account.
As Kirk Jewell, certified financial planner (CFP) and president of Global Financial Services pointed out, “you receive tax-deferred growth as the policy grows and when you go to use the funds for retirement. If set up properly, you can receive tax-free distributions.”
The double benefit is that the wealthy policy owner gets this tax break during his or her lifetime. After his death, the amount of the policy benefit goes directly to the lucky beneficiary he named, who receives it tax-free, minus any amount the policy owner spent.
Jewell said that you can’t buy any random life insurance policy and expect this tax treatment. You should consult a qualified and experienced financial planner or insurance agent. Also, you’ll want to 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.
6. Deducting Theft and Casualty Losses
Julian Block, an attorney and former IRS special agent, said that you might be able to deduct your losses if someone robs your house or the basement is flooded. Of course, you can’t intentionally lose or damage your property to get a tax deduction.
“The IRS allows deductions for household goods, homes and other kinds of property lost or damaged because of burglaries and vandalism,” Block explained. “Ditto for casualty losses, provided they are caused by identifiable events that are ‘sudden, unexpected or unusual,’ such as fires, floods and hurricanes.”
Block, a former IRS criminal investigator, also said that “the IRS severely restricts the allowable amounts for theft and casualty losses and knows that complex rules cause many individuals to overstate their deductions, which accounts for why its investigators ask probing questions about lost or damaged household possessions and other categories of personal property.”
Homeowners usually can’t prove to the IRS the value of their lost property because they don’t keep adequate records. What can you do to have a better chance to deduct your losses? The IRS provides a free guide, Publication 2194, Disaster Losses Kit for Individuals. It includes a workbook to list all your current household goods and personal property in every room of your house.
Having records of your belongings will be helpful in the unfortunate situation that you want to file an insurance claim or deduct amounts on your income tax for theft or casualty losses.
7. Buying a Yacht or Second Home
Most of us don’t have the cold, hard cash to buy a second home at the beach or a boat. Even so, it’s hard to understand how having multiple residences could lessen a rich person’s tax bill.
Here’s how it works: 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 your mortgage. If you buy a second home, you can deduct the taxes and mortgage interest on that property also.
Kay Bell, tax journalist at the blog Don’t Mess With Taxes, explained that your yacht could qualify as a second home, provided it includes sleeping quarters, a kitchen and a toilet. This strategy probably isn’t practical for those who can maintain only one primary residence and aren’t able to buy another home — particularly an expensive one that floats.
Keep Reading: 5 Tax Law Changes for 2016 You Need to Know
The wealthy might try to keep these and other tax minimization strategies as their secrets. If properly utilized, these schemes are legal for the rest of us as well.