Happy Thanksgiving, and I promise you will want to give thanks for this post… Yet another installment in my “Book Learning” series, this one’s a doozy. If the title doesn’t sound promising enough, I’m going to show you one of my strategies for getting tax-free wealth.
The book has SO MUCH in it, it would be impossible to cover it all, and that’s why I’m focusing on a specific strategy. I strongly encourage you to get your hands on this book and read it through. It covers all types of investing, how you can use legal entities to your advantage, and how your taxes will ultimately be impacted.
Before we get into the meat of it, let’s cover one important issue: If you believe that paying a lot of taxes is your patriotic duty, then maybe you shouldn’t read on. But at least consider this other perspective first: The vast majority of the tax code is incentives. The government realized that if they wanted more housing built, they would give a tax break to those who did that. If they wanted people to create jobs, they would give tax breaks to businesses that employ people. So maybe, just MAYBE, paying $0 in taxes means you’re doing exactly what your government wants you to do, and you couldn’t be more patriotic.
“The hardest thing in the world to understand is income taxes.”
The complexity of the US tax code is incredible, and many other countries are just as bad. Rather than trying to read through it all, I recommend you learn some basics, just enough to be dangerous, and then you get professional help when working on specific deals in your life. This post is meant to cover a few basics; contact someone (like me) if you want further help.
TYPES OF INCOME AND HOW THEY’RE TAXED
First, let’s look at the three main types of income, in order of tax percentages paid, from highest to lowest:
- Earned – if you work for this income, you’ve earned it. Isn’t it sad that this is the highest taxed type? Bust instead of crying about it, consider the reasons why the government has organized it like this and how you can take advantage of the other types. Example is your 9-5 job.
- Capital – this basically means you bought something for $1 and sold it for $2. There is different treatment based on if the turnaround was short-term (within a year) or long-term (longer than a year). Example is buying bitcoin for $1 and selling it for $8,000.
- Passive – very complex to define in some cases, but it is what it sounds like: If you don’t have to do much to get this income, it’s taxed at the lowest rate. Example is rental income.
An important thing to note is that losses in any one category can only offset gains in that same category. This gets as specific as saying that long-term capital gains can only be offset by long-term capital losses in the same tax year.
TAX-FREE CASH FLOW
The easiest example to demonstrate tax-free cash flow is real estate, but keep in mind that running a business allows you to take deductions from your cash flow as well. Maybe you wouldn’t get to $0, but you can still shave down that taxable income. Let’s take a look at a rental property example:
- Buy a house for $330,000, which overall costs you $2,000/month.
- Rent it out for $2,500/month, giving you $500/month cash flow.
- Among other deductions that you can take on this investment, the golden one is depreciation. Over 27.5 years, you will depreciate the value of the home. This gives you a phantom loss of $1,000/month.
- At the end of the year, you have $6,000 in your pocket, but you showed a passive loss of $6,000, so no tax is owed.
As if the above tax-free rental income wasn’t good enough, here’s the heavy whipping cream on your pumpkin pie this Thanksgiving: If you can find a way to get $6,000 more in passive income, that can also be offset by the remaining $6,000 passive loss from your rental property. One of the ways you can do this is by investing in a small business.
There are many specifics that go into defining someone as a passive investor versus an active one, but, if done correctly, it can be a fantastic way to get more cash in your pocket, and KEEP IT.
There are many ways that we can lose money in this world. The government is going to be the largest one for many of us. In my humble opinion, minimizing the amount we pay to the government, if done legally, is a great idea. I’m confident that I’m a better steward of that money than the US government is anyway…
Here are some questions for you to get you thinking. Please comment or send us a note!
- What source of income is your biggest?
- How are you going to get passive income?
- Do you think paying $0 tax is good, bad, or neutral?