FINANCE: SAVINGS ON TAXES
Author: Lew Wessel | Photographer: Photography by Anne
In the early 1980’s, the top income tax bracket was a whopping 50 percent. As onerous as that may sound, “tax shelters” were readily available to reduce the actual tax bite. These “shelters” were investments that typically generated huge non-cash losses that would reduce taxable income dollar-for-dollar; most were, to quote Professor Michael Graetz of the Yale Law School, “a deal done by very smart people that absent tax considerations would be very stupid.” Most of these investments involved rental real estate (commercial or residential), because buildings generated lots of depreciation—a non-cash expense. However, “shelter” investments also included boxcars, cattle breeding, oil and gas ventures, movie production and more.
The tax shelter industry—and it truly was a multibillion-dollar-per-year industry—came to a crashing, albeit temporary, halt with the passage of Ronald Reagan’s Tax Reform Act of 1986. This act was unofficially known as the “Tax Simplification Act of 1986,” because it significantly reduced the number of tax brackets, closed countless loopholes, and eliminated preferential treatment of capital gains and dividends. Unofficially, the law came to be known in the CPA world as “The Tax Accountant’s Relief Act of 1986,” because in order to eliminate tax shelters, it added a whole new layer of complexity to the tax world with the introduction of the concept of “passive activity income or loss.” A passive activity income or loss is one derived from real estate investments or any other investments where the investor does not “materially participate.” There are lots of factors in determining material participation, but essentially, at least a 500-hour-per-year commitment and a significant role in running the activity are a must.
Under the new 1986 law, losses from a passive investment could no longer be used to offset any other type of income, e.g. from salaries, an actively run business, interest, dividends, etc. until the investment was sold. Poof: the end of tax shelters for doctors, lawyers and other high-income taxpayers. In return, taxpayers got a 28 percent top tax rate.
Flash forward to today’s tax code. A lot has changed. The top tax rate is now 35 percent on taxable income in excess of $388,350 per year. Offsetting this increase is, of course, the preferential tax rate of 15 percent on both dividends and capital gains. What has not changed dramatically for individuals is the basic structure of the tax code since 1986, which is designed to inhibit the ability to shelter ordinary or investment income. So, how can you save on taxes today? Here’s (some of) what you need to know…
Make less money. This is my usual obnoxious answer to the question of how to pay less tax. It’s fine to want to reduce your tax bill, and I’m happy to help you do just that. To paraphrase Judge Learned Hand, there is no obligation nor is it particularly patriotic to pay more taxes than you legitimately owe. Nevertheless, please don’t whine about being in the 35 percent tax bracket unless you want to get socked by someone in the bottom 99.4 percent of taxpayers who don’t earn enough to be in that bracket. Yes, it is a fact that only 0.6 percent of taxpayers are actually subject to the top tax bracket of 35 percent.
Give it away. Giving money to an approved charity will get you a deduction and reduce your taxes. The smartest way to do so for many taxpayers is to donate an appreciated long-term asset such as shares of stock or a mutual fund directly to a charity or through a donor-advised fund such as the Fidelity Charitable Gift Fund. Donations made this way are deducted at full value, but the appreciation in the donated asset is not taxed. Giving away cars and other personal assets to Goodwill and the like are also great ways to reduce your taxes, but be aware that special rules have been put in place to curb many abuses in this area. Creation and donation of conservation easements on land you own is another powerful tool, but requires significant planning and documentation.
Tax preferred investments. Income from dividends and long-term capital gains (investments held more than a year) are taxed at 0 percent for those in the 10 or 15 percent tax bracket (up to $70,700 for a married couple in 2012) and a maximum of 15 percent for those in the higher brackets. By contrast, interest income from corporate bonds or banks is taxed at the full rate. All things being equal, you will save taxes by shifting your safe CD money to dividend paying stocks; of course, you may lose all your money on a bad stock, so there’s that to consider.
Municipal bonds are not taxed on your federal return, or on your state return if issued by your state. In other words, look for great bonds issued by the State of South Carolina or an entity within the state, such as Beaufort County, if you want totally tax-free interest income. Make sure to ask your broker if the municipal bond is subject to the AMT (we’ll discuss that some other time).
Retirement accounts. Every dollar you put into an IRA, SIMPLE, SEP or a qualified retirement account such as a 410K reduces your taxable income for the year. This is actually a deferral of taxation, since these same dollars will be taxed at full rate when they are later withdrawn. Withdrawals, for you youngsters out there who may not be aware, are required to begin at age 70 and a half. Note: a contribution to a Roth IRA or Roth 401K does not reduce your current taxable income; the appeal here is that withdrawals are never required nor taxed if taken.
A particularly powerful tax savings/deferral tool in this arena is a qualified “defined benefit plan” for small business owners and professionals. These are relatively expensive to set up and maintain, but, under certain scenarios, they can legally wipe out hundreds of thousands of dollars of taxable income for many years. Consult your tax and/or pension professional on this one.
Oil and gas deals. These investment deals, usually available only to qualified investors (over $200,000 annual income and/or $1,000,000 investable assets) are as close to a classic tax shelter as most individual taxpayers can get. Unlike other passive investments, “losses” on these deals, in the form of intangible drilling costs, can be deducted immediately and can be used to reduce ordinary income. In addition, revenue from actual production is entitled to be offset by a 15 percent “depletion allowance.” Again, you can lose 100 percent of your investment in one of these deals, so don’t get blinded by the tax goodies.
Master Limited Partnerships. MLPs are publicly traded partnerships that usually invest in oil and gas pipelines and storage facilities. Shareholders are actually partners, and dividends are actually distributions of partnership cash. As a partner, you receive an annual statement called a K-1 that tells you and the IRS how much income the partnership earned for you. What makes this a tax saver is that you are taxed on the income, not the distribution; that income is often zero or less, thus making your distribution non-taxable. MLPs are complicated, but based on the large number of my tax clients who have invested in them, they are becoming very popular.
Rental real estate. The 1986 act stamped “passive” on all real estate, nevertheless, it allowed and still allows a deduction for losses from rental income for lower and middle-class taxpayers. If you actively participate in the rental activity and your adjusted gross income is less than $150,000, you can offset up to $25,000 of your rental losses against other income. Depreciation is always allowed to offset the income from the rental property, so even if you can’t deduct a loss, you can always reduce your rental income by this non-cash expense. Excess losses are not lost forever but are, instead, suspended and available on future tax returns to reduce rental income.
Installment sales. The basic structure of our tax code has always included the concept of only taxing earnings that you have actually or constructively received. Thus, if you sell an asset and make a profit, you can stretch out the time you pay taxes by spreading out the time you are paid. Again, you incur a risk by not being paid up front, but that’s a decision you are allowed to make.
Like-kind exchanges. Rather than sell a piece of real estate, pay taxes on the gain and then reinvest in another piece of real estate, the tax law, allows—actually prescribes—a tax-free exchange from one investment into another “like-kind” investment. The procedural rules are very strict in this area, but the concept of what constitutes like-kind is very flexible. For example, an investment in a piece of raw land in Pennsylvania can be exchanged tax-free for an office building on Hilton Head. Make sure to consult a tax professional before you contemplate this kind of transaction.
Like-kind exchanges are also available for annuities and life insurance contracts. For instance, the cash value of a whole-life policy can be used to purchase an annuity without immediately recognizing the gain from cashing out the life policy. Again, the rules are very strict, so make sure to consult your tax advisor and/or insurance agent.
Green energy. The government, federal and state, is trying to promote alternative energy use and has some really neat tax incentives that can significantly reduce your taxes. Foremost among them is the 30 percent federal credit for installation of solar panels. South Carolina also allows a 25 percent credit, so, in total, over half of the cost can be subsidized. When the actual savings on utility bills is added in, this is a very attractive tax savings opportunity.
Caveat emptor! Despite the Tax Reform Act of 1986, there is still a tax shelter industry trying to sell you its wares. Some of these shelters are legit; some are out-and-out frauds, and some are “iffy.” The IRS has developed a heightened awareness of abusive tax schemes, and the law now requires that a disclosure statement be attached to every return where an individual participates in a type of shelter transaction that the IRS deems to have a high potential for tax avoidance and evasion; i.e. the IRS demands to be alerted to any “clever” tax schemes in which you participate. Penalties are severe for both non-disclosure and/or participation in abusive tax shelters. The obvious point here is to be very cautious; if it sounds too good to be true, it is!
Note: Many thanks to Donald L. Korb, Chief Counsel, Internal Revenue Service. Many of the ideas in this article are based on a paper he delivered to the University of Cambridge, Cambridge, England on 12/14/2005
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