It never quite made sense to me why when you’re applying for a mortgage they ask about your gross income. You know, your income before taxes. Who cares what your gross income is??? If you make $100,000 per year are single and rent an apartment you’ll probably pay your full federal tax of $22,110.75. Factor in your state income tax (let’s say it’s a conservative 3%) and your FICA (7.65%) and your take home is around $67,200. That’s a total of about 32% or about 1/3rd of your total income going to Uncle Sam. Kinda depressing isn’t it? (Did I forget to mention the sales tax on everything you purchase, too?)
Now let’s say you’ve done some homework and decided to buy (~$14,000 in interest and $2000 in property taxes) instead of rent. You even felt that it was a good idea to make a few charitable contributions (another $5000) and invested the maximum allowable amount ($4000) in an IRA and assume your state doesn’t allow any of those deductions. Now your federal tax bill will be $14,423.75. A savings of almost $8k in federal taxes alone. Your take home after taxes jumps to ~$74,900. Keep in mind, that after your charitable contributions, property taxes, interest, and IRA your take-home that you can spend on sports cars and flat-screen TV’s will only be ~$50,000. However, you now have a house that hopefully is appreciating and a retirement account so you’re ahead of the game. But let’s face it – you still don’t have tons of cash as compared to the total cash that you earned.
Now here’s the real exciting part. If you have a business that pays for your car, for your cell phone, and your internet access (pre-tax), since you work from home at times, you’re starting to get WAY ahead of the tax man. Add in some passive income from a rental property (since you won’t have to pay FICA on residual income) and your NET (after-tax) income just keeps climbing. If your business is filing as an S-corp, you take a “reasonable” salary, and take the rest out in distributions you again avoid the FICA taxes. Tax minimization is one of the greatest advantages of being an entrepreneur. In the scenario above, if you take out $50,000 in salary and pay the remaining $50,000 in distributions, your tax bill drops another $3825 (which is direct cash to your pocket).
Before I get into The Ultimate Tax Shelter, Jeff Schnepper in How to Pay Zero Taxes 2009 points out a few fun facts for us:
- The average middle-American salary in 2005 would take about 107 days of 100% of income going to Uncle Sam to pay off his taxes! In 1930 it took only 57 seconds of work to pay your taxes.
- On Average Americans spend more time working to pay their taxes than they spend working to pay for food and shelter combined (as an employee I KNOW that was the case for me).
- In 2004, 42.5 million tax returns – one third of all filed – had no income tax liability because of the available deductions and credits
- For the tax year of 1998 2,085,211 individual tax returns showed income of $200k or more. Of those, .07 percent or about 1,467 returns, showed no U.S. tax liability! By 2001 that number jumped to 2,959 returns! (This statistic is my personal favorite)
My point is you pay too much tax. However, as I always stress, you don’t need to cheat the tax man by doing anything unethical. You play by the book and educate yourself properly and you won’t have to. With that in mind, my accountant confirmed what How to Pay Zero Taxes 2009 recently taught me – an amazing tax shelter – resort rental properties.
Obviously as a rental property it has all of the advantages of passive income:
- No FICA (7.65% of wages)
- Potential for paper loss along with a positive or break-even cashflow for great tax deductions
- Appreciating real estate
- Minimal management (most resorts offer management companies)
- A vacation home to use when you want!
Without any of the draw-backs:
- NO Necessity of being an “Active Participant”
- NO Limitation of $25,000 of passive losses against active income
- NO Phase-out of all deductible losses starting at $100k and completely erasing all deductible losses by $150k
This scenario is because in any property where the average rental term is less than 7 days it’s considered a hotel/motel and the income (and loss) becomes active with no limitation on the loss. In other words, it becomes its own business with all the normal business perks. (Have your accountant reference Treasury Reg. 1.469-5T(f)(2)(ii) for more details.)
Let’s take it even a step farther. Once you start your vacation rental business, you decide it’s a pretty good business to be in and so would like to invest in more resort rental properties. Your spouse and you are both shareholders so you decide to take a trip to evaluate more properties. That tax-deductible trip can be to the local ski-resort, to Hawaii, or around the world. After all, you need to evaluate 50 businesses to find the right one, how many resort rental properties will you have to evaluate before you find a great one?
Unfortunately, in my experience, your accountant is rarely going to come up with great tax-savings ideas for you… The average accountant seems to be too busy with the “basics” and effort taking care of those monotonous details, to get real creative. I’m not real sure exactly why that is… At any rate, it’s your responsibility, not your accountant’s, to make sure you’re not paying too much tax!
Don’t ever forget that NO investment should be made solely for a tax deduction. That’s not only poor business planning, it’s actually illegal. You make your real estate investments based on the potential for appreciation and ultimately that the money you put in will be less than the cash you take out.
As an entrepreneur it’s important to build your team, educate yourself on technology, train yourself on marketing and a host of other things – but why do all that work while donating 107 of your hard-working days to the tax-man? It’s poor business and probably poor for your health considering the possible depression that it can induce.
To your NET success, Bryan