What if you could live in a world without taxes? Where each dollar you earn is a dollar you keep. It may surprise you, but thousands of wealthy Americans pay no income taxes. Indeed, the IRS reported in 2011 that about 9,000 taxpayers with incomes over $1 million were able to keep their taxes at zero. It may seem unbelievable, but living a tax free life, or paying minimal income tax, is one of the secrets of the super wealthy. So this post will explain the 3 steps to never pay taxes again.
3 Steps to Never Pay Taxes Again
Wait a second…I thought the only inevitable things in life were death and taxes? You’re telling me that only death is inevitable now?!?! How is this so? The esteemed USC law professor Edward J. McCaffery calls it “Tax Planning 101—Buy, Borrow, and Die.” Read on to find out how it works.
Step One: Buying
The first step to living tax free is to buy an asset that rises in value without producing cash, such as growth stocks or real estate.
Many investors will borrow during this step as well in order to get the most bang for their buck. Smart debt is the best kept secret of the wealthy. As odd as it may seem, the tax code is designed to support American indebtedness. There is no federal tax on consumption or borrowed money. There are even many deductions for paying off loan interest, such as mortgage interest or business-related debt interest.
The wealthy use smart debt to leverage their investments and use the income from their investments (e.g. rental income) to pay off loan interest, principal, and any operating expenses. Because paying off principal is not a deductible business expense, smart taxpayers receive depreciation deductions to eliminate taxable income.
Using this strategy, the asset is paying off its own principal and interest while theoretically appreciating in value. Since you are the owner of the property, all the appreciation belongs to you, not the bank. For instance, take this simplified example: let’s say you own a $1 million property with $200,000 equity and an $800,000 mortgage. Assume the monthly rent covers the principal, interest, and operating expenses. At 3% appreciation and 3% original principal payoff, your equity grows by $54,000 that year. That is a 27% return on investment.
Step Two: Borrowing
When the principal of the debt is sufficiently paid off, the taxpayer refinances the loan. He or she will receive another loan for the property, and the terms of that loan will be based on the appreciated value of the property. The new loan will be used to pay off the remaining debt—the rest can land in the taxpayer’s pocket.
This refinance payment is still a loan, so it is tax free. The taxpayer can use that money for leisure and living expenses as the income from the property (e.g. rent) begins paying off the new loan to re-start the cycle.
For another example, let’s continue with the 3% appreciation and original principal payoff after 5 years. Assume the taxpayer refinances with the same interest rate. In 5 years, there has been $159,274 in appreciation and $120,000 in paid-off principal. If you keep the 20% equity, 80% debt financing, the bank will issue a new loan worth $927,419. Subtract your previous balance of $680,000 and you find $247,419 in your pocket. Tax free. That’s about $50,000 a year.
Step 3: Kicking the Bucket
Can this go on forever? The short answer: yes, but you will be long gone.
As the taxpayer continues to take depreciation deductions, the basis of the property will reduce proportionally each year and ultimately reach zero. With zero basis in the asset, the taxpayer can take no more deductions and if he or she were to sell the property, outside of a 1031 exchange, she would be taxed on every penny, not just the profit.
But, death brings sweet tax-relief because assets that are willed to heirs receive a new, “step-up” basis. The new basis will be stepped up to the fair market value of the asset at the time of death. So even though the taxpayer used up the entire basis and the asset is worth several times what it was originally purchased for, the heirs of the taxpayer can start the cycle over with a fresh new start for tax purposes. If an heir were to receive the asset and sell it that same day, it could be done tax-free.
Note that this is a simplified account of the process. Handling these properties is a business, and there will be complications, as with any business. Changes in the market, accidents on the property, or a plethora of other unfortunate events could complicate things or lead to additional expenses.
You would be wise to consult with a qualified accountant and real estate attorney before jumping into the process, as there will inevitably be legal and tax consequences that you may be failing to consider, such as which entity to use for a real estate investment.
That said, these were rather conservative numbers. Many professional investors can secure loans with even higher leverage than 80%, some as far as 5%. Changing your equity stake from 20% to 5% could effectively quadruple your return on investment.
Further, the assumed 3% principal repayment was lower than even a highly conservative 30 year repayment plan, which is 3.33% average annual principal repayment. Most investments repay the principal significantly faster.
If you’re interested in living a wealthy, tax-free life then investing in real estate is a great way to go. If you’d like to find a qualified real estate or tax lawyer to help you out with the process, check us out.