Everybody wants to pay less taxes, but not everybody knows how. This article comes up with a logical solution to pay less taxes so you can be more free.
By now you’ve probably heard that Donald Trump supposedly only paid $750 in federal income taxes in the year he ran for president and in his first year in the White House, according to a report in The New York Times. Whether this is true or not, nobody can be sure since Trump said the information is fake news given his tax filings are still under audit.
The president’s financial disclosures indicated he generated at least $434.9 million in income 2018, but his tax filings reported a $47.4 million loss. Therefore, it’s a little mind-boggling to normal people like you and me as to what is exactly going on here.
At least Trump has employed thousands of people and his company has paid tens of millions in FICA tax each year as a result.
Even though roughly 45% of Americans pay no income taxes (mostly due to low income), in 2017 the average tax filer paid roughly $12,200, or about 16 times more than what the president paid. Therefore, if we are to be honest, I’m sure the 55% of Americans who do pay income taxes would love to pay less.
Instead of getting mad at a supposed billionaire for not paying a lot of federal income taxes, we should take this opportunity to learn how to minimize our tax liabilities as well. So long as we can legally minimize our tax liability, we should.
After all, financially savvy people are always looking to minimize expenses and maximize earnings.
How Regular People Can Pay Less Tax
You and I are regular people. We aren’t billionaires nor do we wield positions of great power. Therefore, a lot of the tax avoidance strategies available to the rich and powerful are not as readily available to us. That said, I’m going to first come up with a framework so that all of us can pay less taxes.
To start, the easiest way that regular people can pay less taxes is by making less income. Single filers get a standard deduction of $12,000 while married couples get $24,000. Therefore, if you want to pay no income taxes, then make up to $12,000 a year as an individual or up to $24,000 a year as a couple and voila! You won’t pay any income taxes.
The problem with this low-income strategy is that it’s hard to live off only $12,000 / $24,000 a year for most people. Some families food budgets, alone, are greater than $12,000 / $24,000 a year.
Unfortunately, no single person or married couple can comfortably live off only $12,000 or $24,000 in income. Hence, focus on itemized deductions if you can.
Further, regular people can max out their 401(k) and IRA contributions and thereby reduce their taxable income. After decades of contributing, I expect all of us to at least become 401(k) millionaires.
Regular people can buy a primary residence and take advantage of mortgage interest and property tax deductions. When it’s time to sell, regular people can pay no capital gains tax on up to $250,000 in profits if single or $500,000 in profits if married.
Finally, we can all donate more to charity to reduce our taxable income. It is better to give to causes we are passionate about rather than to pay more in taxes to a wasteful government.
How Financially Savvy People Can Pay Less Taxes
Now that we know how all of us regular people can pay less taxes, let’s take things up a notch. Here’s how financially savvy people can pay less taxes. Financially savvy people are those of you who want to achieve financial freedom sooner, rather than later.
1) Learn The Tax Rates By Income Levels
The key to paying less taxes is understanding the tax rates for various types of income and what type of items can be deducted from income.
Unfortunately, most people make most of their money through a day job. Day job, or W2 income, is taxed at the highest rate.
The goal is to make the most amount of income that is taxed the least. Therefore, people need to get into the mindset of building as much passive investment income as possible in order to pay the least amount of taxes.
The easiest way to approach tax rates by income is to divide the tax rates between short-term capital gains tax rates and long-term capital gains tax rates. Short-term capital gains tax rates are also equivalent to regular federal income tax rates.
If income tax rates change in the future, we must know each tax rate as soon as it comes out.
2) Earn Income Where The Tax Rate Differential Is Greatest
The income level where the difference between the short-term and longer-term capital gains tax rates is greatest is between $82,501 – $425,800. Once you get between $200,001 – $425,800 you experience the largest tax rate differential of 20%.
The 20% tax differential is one of the reasons why I had a goal of generating at least $200,000 a year in investment income before I had children. Back in 2012, I thought $200,000 was the ideal income for maximum happiness as an individual. I didn’t just pick a number out of thin air.
Now that I have two children and a wife to support, my passive investment income goal is $300,000 – $350,000 a year, which is still in the maximum tax differential range. I could aim for $425,800 in investment income, but with a declining safe withdrawal rate, the amount of capital required to generate such a passive income figure is too much for me.
By paying a 15% marginal income tax rate versus a 35% marginal income tax rate, a person can make about 22.4% less on the marginal income and still end up with the same amount after tax.
For example, at a 15% marginal income tax rate, $100,000 of the income above $200,001 becomes $85,000 after taxes. To end up with $85,000 after taxes at a 35% marginal income tax rate, you would need to earn $130,769 in income above $200,001.
3) Earn the lowest-taxed income from investment income
At this stage, you’ve gotten into the mindset of earning more passive income and achieving a certain passive income target. You’re no longer making fun of people like me for trying to live a middle-class lifestyle off $300,000 a year because you understand tax optimization. You also understand that the cost of living is different throughout the country.
It’s time to earn the best-of-the-best type of income to pay the least amount of taxes. The two best types of income to earn are rental property income and business income. Earning income through these two sources are tax-efficient due to deductions and flexibility.
You can also invest in tax-free municipal bond income as well. However, with interest rates so low and municipal bonds having performed so well, the future returns likely won’t be as attractive.
Let me demonstrate how to legally pay less in taxes through rental property income and business income.
How To Pay Zero Taxes on Rental Property Income
Thanks to loose monetary policy, strong demographics, and a growing desire to own hard assets, owning rental properties is one of the best ways to build wealth and generate relatively stable passive income.
Below is a simple chart that shows how to pay zero income taxes with rental property. The key lies in all the available deductions.
Owning a rental property is like owning a business. Almost all expenses related to running your rental property are deductible from the rental income.
Some common rental property expenses not included in the chart are advertising, transportation, supplies, cleaning, phone, and tolls.
A key part of the expense is depreciation of the building value (not land). Depreciation is a non-cash expense to provide a fair way for the normal depreciation of your property. In the example above, we have a rental property building valued at $633,308 taking a $23,000 annual depreciation expense for the next 27.5 years.
There’s no escaping property taxes again, but at least it is deductible. It’s important to convince the city your property is worth the least amount possible to pay the least amount of property taxes.
If you have a high W2 income, owning rental property is a tax-efficient way to generate cash flow. Imagine amassing 10 rental properties, all generating $23,000 a year in tax-free rental income a year thanks to depreciation. That’s $230,000 a year in tax-free income!
The Downside Of Rental Property
The biggest downside to owning rental property is the time it takes to find good tenants and maintain the property. If you get unlucky and end up with tenants who don’t pay on time or pay at all, your returns will really suffer.
Further, your property is also subject to natural disasters. Hopefully, you will have a strong enough homeowners insurance policy to not only cover your property’s damages, but to also make up for lost rental income.
The older and richer you get, the less you want to deal with maintenance and tenants. This is where owning REITs and participating in real estate syndication deals become relatively more attractive.
Platforms like Fundrise, which has private eFunds for non-accredited investors, has really grown in popularity thanks to its more stable passive income source. It’s free to sign up and explore.
How To Pay Less Taxes With A Simple Business
Creating a portfolio of rental properties is like creating a business. You can create an LLC and inject all your rental properties into your LLC for liability protection.
You can also create many other traditional types of businesses to earn tax-efficient income. Below is an example of a cupcake business with net revenue of $90,000 and taxable income of $65,000 at most. In reality, after retirement contributions and other deductions, the taxable income will be closer to $0.
Starting your own successful business is harder than just working a day job, but it’s one of the most gratifying things you can do. A lot of your normal living expenses, such as your mobile phone and internet bill, can be considered business expenses.
For example, you can have annual board meetings in Hawaii if you want. There’s no requirement to have one in your windowless basement. The to and from Hawaii air tickets, meals, and accommodations are all deductible. If you want to do a team-building event on a luxury catamaran, that’s probably deductible as well.
As an employer and employee, you get to contribute up to $19,500 to your Solo 401K + 20% of operating profits. If you have the operating profit, the maximum 401(k) contribution is $57,000 for 2020. In this case, the person contributes $18,000 + $13,000 = $31,000 that doesn’t get taxed.
You can also contribute a maximum of $6,000 for yourself and another $6,000 for your spouse in a traditional IRA. Eventually you will have to pay taxes on these pre-tax retirement accounts, but not now.
After the Tax Cut And Jobs Act was passed in 2017, a Qualified Business Income (QBI) deduction was introduced for sole proprietors, partnerships, S corps, and some trusts and estates. The deduction is equivalent to 20% of QBI. Therefore, in this cupcake business’s case, it could reduce its taxable income by potentially another ~$8,000 – $13,000.
Business taxes are one of the most complex taxes to calculate. The above is just a simple example of how a cupcake owner with $100,000 in revenue might not have to pay any taxes at all.
How To Pay Less Taxes With A Complicated Business
Now that we’ve mastered the cupcake business, let’s look at a very interesting business case study: Gawker Global, an online media company.
Before Gawker Global went bankrupt, partially due to Hulk Hogan’s lawsuit, it had one of the most fascinating business structures ever to pay less taxes.
Take a look below at how Gawker Global was able to pay a 4.5% effective tax rate on $1,000,000 in advertising revenue.
The bottom line is that Gawker Global set up a subsidiary in Hungary, which has much lower corporate tax rates than in the U.S. In other words, Gawker Global ended up paying itself and arbitraging the tax rate differential.
If you want to learn more about Gawker Global’s business structure, I wrote a more in-depth post about it. I can’t believe it was legal, but the IRS allowed it for many years.
Running an online business is my favorite type of business to run in the internet age. There are over three billion people online today. The scale and potential profitability of an online business is massive.
Unfortunately, from a tax perspective, due to the low-cost nature of running an online business, the tax bill could also be outsized.
Business Flexibility Is Huge
Flexibility is one of the main reasons why businesses are able to pay less taxes. W2 income earners hardly have any flexibility in comparison. Here are some examples of business flexibility:
- Delay income and expenses. If the beginning of the year is going strong, a business might front-load capital expenditure or backload revenue to the next year. One easy example is depositing client checks received in November and December to January of the next year.
- Decide on the level of business expense. A business can always spend more of its operating profits and retained earnings to try and generate more business down the road. However, not all expenses have the same return on investment. For example, let’s say business is going really well. Instead of taking your staff to the Motel 8 in town, you decide to fly your staff to Aspen and pay for five nights at The Ritz Carlton. Instead of buying a $20,000 Honda Fit as a company car, you can buy a $220,000 Lamborghini Urus instead.
- Where to direct business expenditure. If you own a business, you can decide to hire relatives you care about who are in a lower tax bracket. For example, let’s say your son, whom you love dearly, is down on his luck after graduating from college. He’s living at home with you, but you don’t want to just crush his ego by giving him money. Instead, you can pay him $12,000 to do some work for your business. He gets to earn $12,000 tax-free and you get to deduct $12,000 from your business income. A win-win! Of course, you could always pay him more.
Pay Less Taxes By Being A Bad Business Person
Finally, just like how you can strive to earn less money as a laborer to pay no taxes, you can also strive to be a terrible business person to pay no taxes.
Money-losing businesses don’t pay income taxes. However, if you can grow your money-losing business to massive scale, you could end up becoming extremely wealthy. Uber is a great example of a money-losing business that made its founders multi-billionaires.
Just beware that after about three years of not making money, the IRS might come knocking. The IRS is not stupid, and knows that some individuals will create a business for the main purpose of sheltering income with questionable expenses.
From the IRS’s perspective, the primary purpose for starting a business is to make money.
Rental Property + Business Income = Best Combination
Hopefully, this article provides a simple framework for how regular folks can legally pay less income taxes. U.S. tax laws are very complicated. There are a plethora of things one can do to minimize tax liability. As a result, many people don’t even try.
After over 21 years of earning multiple types of income, I recommend focusing mainly on earning rental property income and business income if you want to pay less taxes and build the most wealth.
Earning stock dividend income is also great and is a recommended passive income source. However, it’s much harder to shield dividend income. Earning municipal bond income is also a wonderful source of tax-free income. However, returns are now very low.
Eventually, the lion’s share of your income will come from tax-efficient sources. When it does, you will no longer feel as bitter or as burned out by a wasteful government that progressively taxes you the more you make.
If you can buy one rental property every 2-5 years and work on your online business, over a 20-year period, you’ll be set for the rest of your life.
I can’t guarantee you’ll be able to pay only $750 a year in federal income taxes without deducting $70,000 worth of hair expenses. However, if you build rental property and business income, I’m sure you will pay much less in taxes than a typical W2 laborer with the same income.