Rich Have the Same Shelters as Others, but Better Leverage
The secret to tax savings once was unlocked only for the wealthy. Exceptionally well-heeled taxpayers would invest in wind farms, race horses and oil wells, and somehow that would reduce their taxes by tens of thousands of dollars.
But those shelters have been largely eliminated, and there are few remaining mysteries to cutting your tax bill.
“People seem to think there is some secret insight you get if you make a certain amount of money,” said Tim Kochis, national director of personal financial planning at the accounting firm of Deloitte & Touche. “The truth is, there just is very, very little you can do anymore.”
The things the rich can do are essentially the same things everyone else can do to lower their tax bills. Contribute to tax-advantaged retirement accounts. Buy a house. Give to charity. Try to time the receipt of income and deductions for maximum financial and tax benefits.
The main difference is the rich tend to use their shelters and deductions in a bigger way than everybody else, said Phil Holt-house, partner at the accounting firm of Parks Palmer Turner & Yemenidjian. They can afford to.
Consider a hypothetical couple--call them Edward and Barbara Standish--earning $500,000 annually. A total of $450,000 comes from salaries, and Ed earns another $50,000 by serving on two corporate boards. The couple has a $1-million mortgage at 10% interest. And they’ve got $125,000 in the bank earning 8% interest.
In 1990, they gave $10,000, or roughly 2% of their income, to charity.
This couple owns an apartment complex, which they bought in 1985. They have $25,000 more in annual expenses on their apartment complex than they receive in rent payments. They will deduct 10% of that, or $2,500, against ordinary income on their 1990 return.
(Some years ago, they would have been able to deduct all of their so-called passive losses against ordinary income. But the 1986 Tax Reform Act has phased out those deductions, allowing for only a 10% deduction against ordinary income in 1990 and no such deduction in 1991, said Edward R. London, tax partner at the Los Angeles office of Urbach Kahn & Werlin. However, passive losses are 100% deductible against passive income.)
Because Edward Standish had $50,000 in self-employment income, he was able to set up a defined-contribution Keough plan and deduct his $10,000 Keough contribution from income.
After subtracting itemized deductions of $150,000--mortgage interest payments, charitable contributions and state income and property taxes--and their personal exemptions and deductible passive losses of $2,500, the couple’s taxable income is $343,400. But at this high income level, they lose the benefit of their personal exemptions, so their tax amounts to $97,300, which is 28% times $347,500 ($343,400 plus $4,100).
How could they save on their 1991 taxes?
For one thing, they should contribute as much as possible to tax-advantaged retirement accounts, Holthouse said.
If either Standish has an employer that offers a 401(k) plan, they could contribute up to $8,475 in 1991 and shelter that amount from taxable income. In addition, interest earnings in these accounts are not taxable until the money is withdrawn at retirement.
They also should consider paying off part of the mortgage on their investment property with money invested elsewhere, Holt-house said. That could improve their tax situation and leave them with improved cash flow as well.
Let’s assume that they are earning 8% interest on a $125,000 certificate of deposit, which gives them $10,000 in annual interest income. Meanwhile, they are paying 11% on the mortgage on the apartment complex they own. If they apply the $125,000 against the mortgage, they would save about $13,750 annually in mortgage interest payments.
Since their investments pay only $10,000 annually, that would make them $3,750 richer--the $13,750 savings on the apartment loan minus the $10,000 in investment income it cost them.
Additionally, they would have no investment income, so that would save them $2,800 in federal tax ($10,000 times 28%).
If they wanted to take the case another step, they could borrow another $100,000 against their personal residence--a home equity loan--and use it to pay off more of that apartment loan.
That converts their non-deductible interest expenses into fully deductible expenses. In the end, those two steps would probably wipe out their $25,000 annual loss on the apartment and save them a significant sum in taxes. (Their cash flow would not be significantly changed after the home equity loan because they would probably pay about the same on this loan as they had been paying before on the apartment loan.)
The combination of the 401(k) contribution and restructuring their debt reduces the couple’s tax by $7,270, to $90,030 from $97,300.
HIGH-INCOME COUPLE
Edward and Barbara Standish, our hypothetical wealthy taxpayers, earn salaries totaling $450,000 annually. Edward earns an additional $50,000 annually from serving on two corporate boards. (That $50,000 is considered self-employment income.) They also had $10,000 in investment earnings in 1990. They own an apartment complex, which costs them $25,000 more annually than it pays. And they plan to shelter some of Edward’s “self-employment” income through a Keough plan, which is a tax-advantaged retirement account for self-employed individuals. They also gave $10,000 to charity during 1990.
1990 1991 Earned income $450,000 $450,000 Interest and dividends 10,000 0 Self-employment income 50,000 50,000 Passive loss (deductible portion) -2,500 0 Keough and 401(k) contributions -10,000 -18,475 Adjusted gross income 497,500 481,535 Personal exemptions 4,100 4,100 (2 times $2,050) Itemized deductions: Charitable contributions 10,000 10,000 Property taxes 15,000 15,000 State taxes 25,000 25,000 Interest expense 100,000 110,000 Total deductions & exemptions 154,100 164,100 Taxable income 343,400 317,435 Federal tax 97,300 90,030
Source: Ben Shiao, senior tax manager, Parks Palmer Turner & Yemenidjian, Los Angeles.
