Vol 31 No 11
In just a few more months we’re going to have a different congress, a different President, and a different way of dealing with our budget problems. In a best case scenario, even if Congress doesn’t increase capital gains taxes and income taxes, many of the tax breaks we’ve enjoyed for the past 10 years are going to expire unless renewed. The dollar is under attack on all sides and the country continues to sink deeper and deeper into debt; even as politicians are promising to bail out the distressed housing, the mortgage and banking industries. America is in trouble! If China ever stops rolling over existing debt or stops buying new U.S. Treasury Bonds, we won’t have enough money to repay them what we already owe.
We’ve been in this position before, and we’ve been able to restore fiscal solvency by a combination of factors which included economic expansion, higher taxes, and inflation. This worked in prior years, but we’ve never had to deal with the magnitude of the debt that we now face. Consider that, each month, we are now spending more pursuing wars on two fronts than we did over the entire span of WWII. When we ran up the war tab back in the 40s, Congress imposed a 92% maximum tax rate. When we over ran our budget in the 70s, a 70% maximum tax rate was combined with double digit inflation and a tax credit of 5% for new house purchases to expand the economy and reduce the national debt. This time, it will be much harder to do.
Back then, we exported far more finished products than we imported. Our manufacturing industries didn’t have to deal with foreign competition, voracious energy prices, and mandatory funding of entitlements. Nor did it find itself hemmed in on all sides by government agencies and regulations. Because the dollar was the reserve currency for all modern governments, we could inflate and the world inflated with us. Today, the dollar is losing the battle against the Euro as well as other currencies around the world. If we continue to devalue it by simply printing money to pay our bills, the only recourse foreign governments will have will be to use up their billions buying control of U.S. corporations. This has already commenced.
Let’s see; if private industry is in recession, and government can’t expand the monetary base much more than it has already been expanded, that leaves tax hikes. All the talk about a fair tax and a flat tax that has surfaced during this election year is just that; talk. Too many Americans make too much money because of the Tax Code to allow much tinkering with it. Think of all those tax attorneys, accountants, bookkeepers, financial advisers, lobbyists (and the politicians they court), and industries that rely upon tax breaks to make a profit. How many Americans would be willing to settle for a 25% flat tax when 40% of all Americans pay zero taxes under the current system? How many others could afford or would vote to pay 25% extra tax for each dollar they spent; whether to buy cars, food, houses, or college tuitions; plus gift and inheritance taxes? Would you?
Cutting back on government spending would seem a logical first step in trying to reduce our debt, but that gores everyone’s ox. First of all, entitlements and interest payments consume all but about 20% of the budget. Raising taxes during a recession doesn’t work either. The 1987 Tax Act tried this. It taxed long term capital gain at 37.5%, reduced write real estate write offs, and tightened credit. This destroyed the S&L industry, wiped out real estate partnerships, and bankrupted builders and lenders all over America while increasing unemployment. The economy can’t afford to repeat this when the economy is already staggering.
None of this year’s crop of candidates have even addressed this problem, nor do they seem to be qualified to deal with it realistically. McCain wants to cut taxes again, while Obama want to raise taxes. Given the complexity of our financial problems and increasing pressure on the dollar, it seems clear that no matter who is elected, for most Americans, taxes are going to increase.
TIME IS RUNNING OUT TO USE THE TAX BREAKS WE NOW HAVE . . .
Those who haven’t been subjected to the historically high income, capital gains, and corporate tax rates of prior decades probably don’t appreciate the tax holiday we’ve all been on. When you combine a wide range of business deductions and credits, 0% – 15% taxes on capital gains and dividends, Roth IRAs, tax free residential sales, tax free Exchanging, Installment Sale reporting, tax free trusts, tax free corporate fringe benefits, $12,000 annual tax-free gifts per recipient plus a $1,000,000 lifetime gift per person and tax free inheritance taxes up to $2 million (rising to $3.5 million per person in 2009), and only a token level of tax audits. I doubt if we’ll ever see such a permissive tax climate ever again.
The question is; have you taken fullest advantage of these tax breaks, or have you ignored them because they seemed to be “too much trouble”? During boom times, a lot of tax money is left lying on the table because more money can be made by staying on the offensive to increase gross income – even at the expense of higher tax bills – than by going on the defensive to spend the time and effort to save taxes. But when things slow down and income suffers a decline, employing street savvy tax strategies can make the difference in merely surviving and making a decent living. I’m not talking about slick schemes that usually lead to stressful audits and IRS troubles; I’m talking about using tax laws that are on the books right now to create ways to do business that will save money that might otherwise be paid out in taxes.
Tax strategies start with a review of how you have been earning a living and how you have been spending your money. If you are a sole proprietor, then you have probably been filing your income tax on Schedule C of Form 1040. You pay 15.3% of your earnings out in payroll taxes in addition to your regular income taxes; you will be able to place up to $5000 of your taxable earned income into a Roth or conventional IRA where it often earns a minimal yield. In short, you have been trading off higher taxes than might have been required in return for more having more simplicity in your bookkeeping and tax reporting. Can you afford this today?
Filing a Schedule “C” also puts you into a tax audit pool with the highest probability of an audit. In addition, you’ve placed yourself in jeopardy of having anyone – even a casual laborer – who works for you being deemed to be an employee with a full range of employee benefits, including workers compensation insurance. You’ve also exposed yourself to personal liability for injuries or damages sustained by any of your workers, customers, or others with whom you do business.
On the other hand, if your business were incorporated and elected to be taxed as a S-Corporation, by enduring slightly more complexity compared to a sole proprietorship, note what you would have accomplished: You would have placed yourself into a lower-probability tax audit pool, qualified to have a corporate pension plan into which tax deductible contributions many times as large as your IRA contributions could be made, and had a reasonable percentage of corporate earnings paid to you as dividends taxed at a 0% – 15%; exempted from payroll taxes. You would also have significantly reduced your personal liability for work-related injuries and damages sustained by customers and employees.
If your business were operated as a one-person C-Corporation, to the foregoing tax advantages of the S-Corporation, many of your personal expenses could be paid by your corporation via an employment contract with your corporation that included a large fringe benefit package approved by your Board of Directors. To the extent that these fringe benefits were for the benefit of your corporation, they would be tax-free to you and tax-deductible to it. Among these benefits might be the use of a corporate vehicle, residence in housing provided by the corporation, day care services, medical insurance, attendance at meetings and seminars, etc. all paid for, and deducted by, your corporation. You could also use fiscal year tax reporting that would enable you to use timing strategies not available to non-corporate business entities. The downside is that you would have to keep better records, better books, and observe more administrative formalities.
TAX STRATEGIES ARE BASED ON THE “BIG PICTURE” . . .
I define the day to day things you might do to reduce or minimize your taxes as “tax tactics” rather than “tax strategies”. I define tax strategies as the overall framework within which tax tactics are employed. In the foregoing paragraphs, the decision as to which business entity you selected would be strategic. The way you exploited the particular entity would be tactical. So ENTITY SELECTION would certainly be one of the strategic decisions you’d have to make. An additional decision would be whether to use a non-deductible Roth IRA for which distributions would be tax-free; or conventional IRAs, Simple IRAs, and Qualified Corporate Pension Plans which would be deductible, but whose distributions would be taxable. It all depends upon how the choice might fit into an overall personal strategy. In addition to Entity Selection, the following include more major strategic concepts that you might use to reduce your taxes:
CHARACTERIZATION OF INCOME: Individual ordinary earned income is the highest taxed income because it is subject to both payroll taxes and income taxes. When these are combined, the minimum tax on earned income in the lowest bracket is 25.3%. To the extent that this income can be received from rents, 15.3% of earned income taxes can be avoided. So, if fee Property Managers were to Master Lease the properties that they were managing, the income they received would be characterized as “rents” instead of earned income. Thus it would be exempt from earned income tax treatment. In addition, this income characterized as rent instead of earned income could be sheltered with rental losses that might otherwise exceed the maximum $25,000 limit.
Interest is also not considered to be earned income, but it is still taxed as ordinary income. On the other hand, dividends are taxed the same as long term capital gains from 0% – 15%. Depending on your personal tax bracket, it could pay to switch from income producing to dividend producing investments. A C-corporation could help transform interest to dividends. What’s also interesting is that, to get the lower dividend rate, the corporate stock only has to be held 60 days while to get the lower capital gains rates, property must have been held a full year.
Investing in appreciating assets that that will produce long term capital gains rather than ordinary earned income can shave as much as 20% + 15.3% payroll taxes off your tax bill in addition to State income taxes. One way to do this is to hold a portion of your houses for rental income that is sheltered by depreciation. Each time you buy another house at today’s bargain prices, rather than selling it immediately, hold it as a rental and sell off one of your other long term houses to recoup your costs. This way your gain will only be taxed at 0% – 15%. Depreciation recapture will be taxed at 25% rate, but that could be a minimal amount on a house that’s only been held a year or two. The Alternative Minimum tax only comes into play when gain plus your AMT exemption amount exceeds ordinary income. Small corporations aren’t affected. This exemption is slated to be increased by Congress.
TIMING STRATEGIES: All through the Internal Revenue Code are time limits within which property may be sold at lower tax rates, or dividends can be paid at lower tax rates, or property can qualify for long term capital gains treatment, or a primary principal residence may be sold tax free. Many times, rather than selling a property, an Option can be sold on it on installment sale terms. It might only be exercisable during a time period when the tax effect would be most advantageous. In addition, taxes on gain can be stretched out over many years through the use of installment sales. Gain is taxed in the year of receipt, so it pays to adjust the timing of Note payments to exploit anticipated changes in capital gains taxes. For example, when there is a prospect for a tax cut, it pays to defer receipt of any gain until it will be taxed at a lower rate. This can be done by selling something with interest-only seller financing, with the principal balance of the note being called when it will be taxed at a lower rate. When lower tax brackets are projected to increase, as they are today, the seller on an installment sale can elect to be taxed in the first year of any principal payment at the prevailing rate. Then, even if principal payments continue to come in year after year, they will be tax free.
PYRAMIDING ASSETS TAX FREE IS A VIABLE STRATEGY.
Tax Free Exchanging of property held at least one year for investment or for use in business and/or for rental income enables investors to pyramid their net worth and assets throughout their lives without paying any tax on gain or depreciation recapture. Once a property has been sold and the sale proceeds have been used to buy a replacement property to be held in a qualifying use, the tax basis of the new property can be adjusted to reflect the relative value between the land and the improvements. Moreover, there is no minimum holding period between the time an exchanged property is received and later exchanged into another property so long as this isn’t used to mask dealer activity. You’d be astonished at how swiftly equity can be pyramided via Exchanging. If your long term strategy is to only sell when you can buy replacement properties at 80% of value, by definition, you could grow your portfolio by 20% per year, tax free. Few other investments can match this.
Another way to expand equity is through the use of tax free entities. These would include IRAs, Pension Plans, and Tax Free Trusts. In general, it is a mistake to place real estate into a tax free entity for a number of reasons. First of all, there is no benefit to be gained from depreciation and/or capital gains and, except for Roth IRAs, the income is taxed at ordinary income tax rates when it is distributed. At the same time, holding physical assets subjects the tax free entity to all the liability associated with property ownership. Far better to invest in intangibles such as Options, Rights, Notes, etc.
Once the assets in a tax-free entity grow large enough, they can be sold and the money can be reinvested without the restrictions imposed under Section 1031 for a tax free Exchange. Options can be sold, or traded for Notes. Cash can be invested in discounted Remainder Estates. Fast rising stocks can be leveraged with stock Options. Puts can be bought on falling stocks. Speculators can be financed with shared appreciation Notes. All the profits will be tax free until distributed.
Another often overlooked strategy is to transfer value between parties by gifts. An unlimited number of $12,000 gifts can be gifted by anybody to anybody tax free each year. Currently, $1,012,000 can be gifted tax free to as many parties as desired tax free. If this is spread out in the form of purchase Options among a wide range of assets, all future appreciation will be free of estate taxes to the Option holders.
As much as $2,000,000 can be left to heirs tax free; but this must be reduced by the amount of the $1 million in tax free gifts previously made. By making the above referenced gifts of Options, much of the value of an estate could be transferred tax free. For instance, if an Option were to be gifted to an heir at the price paid on the day a valuable property were purchased, there would be no taxable gift at all, since no value would have been transferred. If the property grew at 7.2% per year, in 30 years the Option value would have grown more than 800%.
One of my favorite ways for an investor to convert fully depreciated real estate assets into income tax free is through the use of Trusts. All that is required is for the entrepreneur to form a Charitable Remainder Trust into which the assets are contributed and subsequently sold. As a condition of the Trust, 5% – 50% of the total assets of the Trust would be distributed to the donor at least once each year. The bad news is that a designated charity would be the ultimate beneficiary of the trust. The good news is that the donor could retain control over the assets to insure that they were invested for maximum growth and income. Moreover, unlike other taxable distributions from conventional IRAs and Pension Plans, distributions would be taxed as they were earned; if from appreciation, then taxed as gain; if from tax-free bonds, then tax free, etc. Better: Income from the Trust could continue for two generations. Best: Contributions to such a Trust would generate an income tax deduction based upon fair market value rather than tax basis.
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