Tax planning is a means of lowering your income tax liability, and can help high-net-worth individuals and high-income earners keep more of their hard-earned money. If done right, tax savings can be very substantial. However, it’s important to know that not everyone qualifies for tax planning, and not all CPAs or accountants specialize in tax reduction planning. In addition, tax planning is not the same as income tax preparation or investing.
In this article, we’ll speak more about a few common tax planning strategies to reduce your tax burden.
How You Save on Taxes: Tax Deductions vs. Tax Credits
If you’ve ever had a mortgage, I’m sure you’ve heard about the mortgage interest deduction. If you have children, you have most likely read about the child tax credit.
What is the difference between a deduction and a credit? And which is better?
A tax credit can reduce the amount of tax you owe, dollar for dollar. A tax deduction can reduce the amount of your income before you calculate the taxes you owe, by a percentage.
A tax credit is better than a tax deduction, as it allows you to save more.
If you receive a $100 tax credit, you save $100 on taxes. If you receive a $100 deduction, you lower your taxable income by $100. If you fall into the highest federal tax bracket (currently 37%), you will save $37.
Some common deductions include mortgage interest deductions, health savings account (HSA) deductions, home office deductions, and business expense deductions.
Some common tax credits include the child tax credit, residential clean energy tax credit, or electric vehicle (EV) tax credit.
The problem with credits and deductions is that many are phased out (lowered or eliminated) based on household income.
As an example, the EV tax credit cannot be claimed by anyone earning over:
- $300,000 for married couples filing jointly
- $225,000 for heads of households
- $150,000 for all other filers¹
Retirement Strategies: Tax Reduction vs. Tax Deferment
Retirement savings are certainly a very important part of our finances, and most of us want to save as much as possible to make this period of our lives as stress free as possible.
There are many ways to save — whether with an employer-sponsored 401(k) or 403(b), a SEP-IRA for those who are self-employed, or a traditional IRA.
Money paid into aforementioned retirement accounts is pre-tax, meaning you are not paying any taxes on contributions and are getting a tax deduction. Most people see this as a “tax saving.”
But is it?
In reality, money paid into these types of accounts is tax-deferred. This means you are not paying any taxes today, while you make contributions, but will be paying taxes upon retirement, when you make distributions.
Most people assume their taxes upon retirement will be lower, as their income will be lower, and this will lead to tax savings.
What if taxes go up?
As of today, the highest tax bracket is 37%. Historically, the highest tax bracket was as high as 94%! Many experts believe that taxes have nowhere to go but up… especially given the tax relief issued to both individuals and businesses throughout the pandemic.
This means that tax-deferred retirement vehicles may not lead to any tax savings whatsoever. They should not be viewed as tax reduction, but rather as tax deferment.
This is why many taxpayers decide to invest in real estate, Roth IRAs, whole life insurance or other types of savings accounts instead of heavily-regulated retirement vehicles.
For more information, read our previous article about retirement strategies.
Tax Planning Real Estate Strategies: Passive Losses vs. Active Income
Almost every week our firm receives a call from a potential client who would like to invest in rental real estate in order to save on taxes. When it comes to tax planning, the assumption is to generate losses (e.g. using a cost segregation study) and deduct these losses against a W-2 wage or business income.
So, can you save on taxes with a rental real estate investment?
The answer is very complex. Here are a four things you should know:
- Investing in real estate is just that — an investment. We’ve seen clients make a lot of money buying, renting, and selling properties, and we’ve also seen clients who lost a lot of money as markets turned. This is because an ROI from an investment is never guaranteed, no matter what anyone tells you.
- Rental income to long-term tenants (unless you achieve professional real estate status), is considered passive income. If you have more expenses than revenue – this is called a passive loss. Many rental properties have passive losses, as a result of depreciation, rental expenses, maintenance, property management fees, real estate taxes, insurance, and other operating costs.
- With various types of business or self-employment income, you can deduct losses on your annual income tax return. With passive losses this may not always be possible – as passive losses can usually only be offset by passive gains (i.e. if your rental property becomes profitable, your passive losses will offset your passive gains, but usually not your active or ordinary income, like from a W-2 job or a business or a 1099).
- Unless you have a passive gain OR sell the property, your passive losses will be carried forward indefinitely, with no benefit to you.
Real Estate Income Tax Planning: What Else to Know
There are exceptions to the above tax planning strategies, but it is very difficult to meet the requirements.
For example, you may be able to deduct passive losses against your ordinary income if you obtain Real Estate Professional status. This is not easy to do, and you must spend at least 750 hours annually in the real estate business, and more than half of your working hours must be dedicated to real estate. You must also fulfill a series of other requirements. This is almost impossible if both spouses have a full-time job, though we have seen successful implementation if one or both spouses give up their job, obtain a real estate license and follow this path.
You can deduct up to $25,000 in passive losses if your Modified Gross Income is under $150,000 annually for married couples filing jointly, and under $75,000 for single taxpayers or those who are married and filing separately. This is only if you can demonstrate active participation in your investment property.
You may also choose to flip homes or do short-term rentals, as losses in these categories are considered active losses. These activities, however, carry more risk and are more time-consuming.
In the end, we see many people purchasing rental properties as they were promised tax savings and deductions. We recommend speaking with a professional about the pros and cons of such a purchase before moving forward, particularly if you’re considering the purchase for tax planning purposes.
4 Tax Planning Strategies for Minimizing Capital Gains Taxes
If you manage to sell an investment for a price higher than your original purchase price (also known as your basis), you will have realized a capital gain. If your sales amount is lower than your basis, this constitutes a capital loss.
There are two types of capital gains, depending on how long ago you purchased your investment. If your asset appreciates and you have owned it for less than a year, this is considered a short-term capital gain. If you have held onto an asset for longer than a year, this is considered a long-term capital gain.
Another thing to remember regarding tax planning: just because you have a capital gain does not mean you will have to pay capital gains tax, which is what we will be discussing below.
1. Use loss harvesting to minimize capital gains.
No matter how big your capital losses are in any given tax year, most of us can only deduct $3,000 in losses annually due to IRS limitations (unless we had a capital gain, as per below). Remaining losses will be carried forward to your next tax year.
A well-known strategy for reducing capital gains is to sell other investments at a loss and use those capital losses to balance the gains for tax purposes. If we make a capital gain of $10, and a capital loss of $10, the net effect is zero, and no taxes are owed.
However, using loss harvesting as a tax reduction strategy literally means you have to lose money on one stock in order to avoid paying income taxes on another.
The reason the strategy is called loss harvesting is because you are using your losses in a strategic, premeditated manner to offset your gains.
2. Spread capital gains over several years.
Another option for lowering your capital gains taxes can be to sell the stock or asset over several tax years — this can help ease the tax burden.
For example, you might sell a part of an investment at the end of the year 2023, then another part in 2024, and the final portion at the start of 2025. The sale will be concluded in a little over twelve months, but tax liability will be dispersed over three tax years.
However, it is crucial to remember that waiting to sell investments or assets involves risks. The tax benefits of holding onto those assets may not outweigh the benefits of a good sale.
3. Donate stocks or assets instead of cash.
If you are already planning on making a charitable contribution, why not donate your stocks?
You could sell your high-performing stocks, pay taxes on them, and then donate the money to a charity and finally claim a charitable contribution deduction (if you’re eligible).
Or, you can make this entire process much simpler by donating stocks instead of money. This way you avoid paying capital gains taxes, still get the tax deduction, and the charity or other non-profit organization of your choice still receives their donation. In addition, the charity may not have to pay any capital gains taxes when they sell the stock.
4. It’s just income taxes.
At the end of the day, it’s important to remember that capital gains tax is just another form of income tax. Any tax reduction strategy that will offset your individual income taxes, such as investment tax credits, can be used to offset capital gains. Perhaps you will be able to hold onto those losing stocks until the market turns.
For a more in-depth analysis of capital gains, read this article.
What to Know About Tax Planning as a High-Net-Worth Individual
Most high-income individuals are well aware of the various retirement strategies, strategies concerning real estate (e.g. 1031 exchanges, cost segregation, etc.), as well as some methods used to minimize capital gains. Based on your unique tax situation, different tax planning strategies can be leveraged to curate the optimal outcome.
In Part 3 of this series, we will be exploring business strategies, strategies for self-employed individuals, whole life insurance strategies as well as strategies for high-income individuals with W-2, K-1, 1099 or business income.
Have questions? Contact us to connect with a Tax Reduction Adviser to see how we can help you lower your tax burden.