Wealthy people understand that it's not how much money you make, but how much of that cash you keep. Earning a fat paycheck is fine, but it doesn't mean much if you end up paying all that income back to the government in the form of taxes.
Smart accountants use every legal trick in the book to minimize taxes and help keep their rich clients wealthy. Even if you aren't a billionaire, you can use a few of these tax strategies to lower your tax bill.
1. 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:
- Office supplies
- A home office
However, not every venture qualifies as a business entitled to such tax write-offs. 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."
How do you distinguish between a hobby — an activity that produces some income — and a bona fide business? The IRS considers many factors that can be found on the IRS 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
2. 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."
Instead of paying high taxes on your business income, transfer some of that income to Junior as wages for services he performs. However, your child's work must be "legitimate," and the salary must be "reasonable," said Gail Rosen, a Martinsville, N.J.-based certified public accountant.
3. Earn Income From Investments, Not Your Job
Instead of working for their money, the wealthy can make their money work for them, said Pompano Beach, Fla.-based accountant Eric J. Nisall, founder of AccountLancer, which specializes in accounting for freelancers.
The tax on earned income can be as high as 39.6 percent. So, consider investing in high-yielding dividend stocks. With these stocks, you 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. People in the 39.6 percent tax bracket pay a 20 percent tax rate on long-term capital gains.
Or, you can invest in real estate by purchasing rental properties. But the process is not easy, and you should learn about your obligations as a landlord before jumping in. Long before you become a landlord and rake in rent money, you have to make a substantial upfront financial investment to acquire the properties and fix them up.
Also, it can be risky to try to pick lucrative properties in the right locations. 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. 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."
Scott Goble, a certified public accountant and financial planner at Sound Accounting in Chickamauga, Ga., explained how this works by imagining someone who purchases a piece of rental property for $200,000 — excluding the value of the land — and holds that property for 30 years. During those three decades, the rental property owner receives a noncash depreciation deduction of $200,000, thus sheltering that amount of income.
Goble then assumed 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," Goble said. "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 from your parents when they die, 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. If they do, they'll owe hefty taxes during their lifetime, and any financial benefit to you will be vastly diminished.
5. Buy 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.
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 his lifetime. After his death, the amount of the policy benefit goes directly to the lucky beneficiary he 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.
6. Deduct Theft and Casualty Losses
You might be able to deduct your losses if someone robs your house or the basement is flooded, said Julian Block, a Larchmont, N.Y.-based attorney and former IRS special agent. 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 said. "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 "the IRS severely restricts the allowable amounts for theft and casualty losses and knows that complex rules cause many individuals to overstate their deductions." That's why IRS investigators ask probing questions about lost or damaged household possessions and other categories of personal property, he said.
Too many homeowners fail to keep adequate records and cannot prove to the IRS the value of their lost property. The IRS provides free record-keeping help in the form of a guide, Publication 2194, "Disaster Resource Guide for Individuals and Businesses." It includes a workbook so you can list all current household goods and personal property in every room of the house.
7. Buy 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. But having multiple residences can 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 the mortgage. If you buy a second home, you can deduct the taxes and mortgage interest on that property as well.
Kay Bell, a tax journalist at the blog Don't Mess With Taxes, explained that a yacht can 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'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.
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 rest of us in cutting our state and federal taxes.
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