As you’ve probably heard, the rich keep getting richer, and one way they do it is with a strategy called tax avoidance.
Billionaires vs. the Middle Class: Who Pays More in Taxes?
Owe Money to the IRS? Most People Don’t Realize You Can Do This – Today
According to the Federal Reserve, the top 1% of U.S. households by income owned 23.3% of the country’s wealth in the third quarter of 2023, up from 22.8% a year prior. Yet the most recent IRS data showed that the average tax rate for the top 1% of individual taxpayers (based on adjusted gross income) was just around 26%.
Unlike tax evasion, which can land you in prison, tax avoidance is perfectly legal, and it’s a strategy you can implement to reduce your own tax bill regardless of your income. You only have to know how to take advantage of some popular tax loopholes the wealthy use to reduce their yearly tax bill. Here are 12 ways to save more on your taxes.
1. Claim Depreciation
Depreciation is one way the wealthy save on taxes. So, what exactly is it?
“For federal income tax purposes, depreciation is a deduction that allows you to recover the cost or other basis of certain property,” tax expert Kelly Phillips Erb wrote in a post for Forbes. “It can be tricky but generally, you begin to depreciate your property when you place it in service for the first time. The IRS considers property ‘placed in service’ when it is ready and available for use, not when you actually begin using it. You depreciate the cost of the item over its useful life (based on the kind of property) unless an exception applies.”
Sponsored: Owe the IRS $10K or more? Schedule a FREE consultation to see if you qualify for tax relief.
How To Get the Deduction
Depreciation can be claimed for both tangible and intangible property. Property that may be eligible for this deduction includes buildings, rental properties, machines, cars and trucks, furnishings, equipment, patents, copyrights and some kinds of software. To qualify for the deduction, the property must meet three requirements:
It’s used for a business or income-producing activity.
You own the property.
It has a determinable “useful life” of more than one year.
Depreciation claims are made in section 179 of your federal tax returns. For tax year 2023, the maximum expense deduction was $1,160,000 for most properties. It has increased to $1,220,000 for tax year 2024.
2. Deduct Business Expenses
If you run a business, you might reap big tax benefits. Business owners who are filing taxes can claim potential tax deductions for some business expenses, including those tied to:
Travel
Vehicle
Office supplies
Work-related education expenses
A home office
Not every venture qualifies as a business entitled to such tax write-offs, however. To qualify, you must intend to try to make a profit in your business rather than engaging in what the IRS considers to be merely a “hobby.”
However, sometimes the lines are blurred between business and hobby. It’s important to know the difference so you don’t miss out on a legitimate deduction — or claim a deduction you’re not entitled to receive.
Discover: The 7 Worst Things You Can Do If You Owe the IRS
How To Get the Deduction
How do you distinguish between a hobby that produces some income and a bona fide business? The IRS considers many factors that can be found on the organization’s website. A few of them include:
Whether you carry on the activity in a businesslike manner, maintaining complete and accurate books and records
Whether the time and effort you put into the activity indicate you intend to make it profitable
Whether you depend on income from the activity for your livelihood
Whether the activity makes a profit some years — and how much profit it makes
3. Hire Your Kids
Business owners who turn their venture into a “family affair” can put more money back into their pockets. For example, hiring your kids to do legitimate work in your business offers potential tax benefits.
Discussing partnerships and sole proprietorships owned by a child’s parents, the IRS noted, “Payments for the services of a child under age 18 are not subject to Social Security and Medicare taxes.”
What’s more, your kids’ income won’t be taxed unless it exceeds the standard deduction. The standard deduction is $13,850 for tax year 2023 and $14,600 for tax year 2024.
Putting your kids to work in your business has an additional tax benefit: You can deduct their wages as a business expense.
How To Get the Deduction
Instead of paying high taxes on your business income, transfer some of that income to your child as wages for services they perform. Your child’s work must be “legitimate,” however, and the salary must be “reasonable,” said Gail Rosen, a New Jersey-based certified public accountant.
Find: 10 Tips To Start a Business With Very Little Money, According to Entrepreneurs
4. Roll Forward Business Losses
Even the wealthy lose money in business sometimes, but they use those losses to their advantage. An IRS rule called a “net operating loss carryforward” allows business owners whose business lost money one year to carry the loss forward to a future year when the deduction would be more advantageous.
“Business losses are sometimes called net operating losses (NOL),” Erb wrote. “An NOL generally results when your tax deductions exceed your taxable income. If that number is negative in one year — but has been positive in other years resulting in tax payable — that doesn’t quite seem fair. The NOL exists so that you can balance that inequity. In other words, you can use the loss in one year to lower your taxable income and reduce your tax burden in another year.”
How To Get the Deduction
In tax years 2018 through 2020, the IRS allowed NOL carrybacks, whereby you would first carry back the entire NOL amount for up to five years, and if you still had an NOL remaining after carrying those losses back, you could carry the losses forward.
Beginning in tax year 2021, those loses are only carried forward for most businesses. “A carry forward means that you can apply the loss towards your income in a future year.” Erb wrote.
5. Earn Income From Investments, Not Your Job
Instead of working for their money, wealthy people can make their money work for them, said Pompano Beach, Florida-based accountant Eric J. Nisall.
Investments that offer distributions such as real estate investment trusts (REITs) and master limited partnerships (MLPs) are set up in ways that can bring in a steady generated income.
Other options include investing in stocks or investing in real estate by purchasing rental properties. Remember, you’ll have to make significant upfront investments before you start seeing returns — and returns are never guaranteed.
Grant Cardone: Here’s How To Become Rich If You’re Earning an Average Salary
How To Get the Deduction
The tax on earned income can be as high as 37%.Invest in high-yielding dividend stocks and collect dividends that the companies pay at regular intervals. Later, you can sell the stock after it has appreciated and pay a relatively low capital gains tax rate. Depending on how much was earned in a particular year, long-term capital gains tax rates are currently 0%, 15% and 20%.
If you own property that you rent out as a landlord, you’ll be able to deduct your property taxes. Remember, though, you have to find tenants who will pay the rent on time and won’t trash your property. Urgent repairs and periodic improvements can be costly, as well.
6. Sell Real Estate You Inherit
If you inherit a piece of property, you can minimize the capital gains taxes by taking advantage of the “step-up in basis.”Normally, if you buy a piece of land for $200,000 and then sell that land for $450,000, you’ll owe tax on that $250,000 gain. However, if your parents purchase the land for $200,000 and you inherit it, your new basis will be the fair market value of the property at the time you inherit it. If you sell it immediately, you won’t owe any tax at all on that $250,000 gain.
See: IRS Increases Gift and Estate Tax Exempt Limits — Here’s How Much You Can Give Without Paying
How To Get the Deduction
The stepped-up basis is an automatic process that happens to all property that passes by way of inheritance. For tax purposes, it’s like you’re starting over, purchasing the property anew at the current price.
In the previous example, if you inherit the property from your parents when they die, you won’t be liable to pay capital gains tax on the $250,000 increase in the property’s value when you sell it using the step-up basis. Make sure your parents don’t give the property to you before they die, however. If they do, they’ll owe hefty taxes during their lifetime, and any financial benefit to you will be vastly diminished.
7. Buy Whole Life Insurance
You ordinarily associate life insurance policies with the need to provide for your dependents if you die. A secret strategy that the wealthy take advantage of is buying whole life insurance. It’s a combination of an insurance policy and an investment account.
How To Get the Deduction
You can receive tax-deferred growth as your policy grows. It’s also possible to receive tax-free distributions under certain conditions.
The double benefit is that the wealthy policy owner gets this tax break during their lifetime. After their death, the amount of the policy benefit goes directly to the lucky beneficiary they named, who receives it tax-free.
Consult a qualified and experienced financial planner or insurance agent. Also, consult an expert to find out if whole life insurance is right for you. Some experts believe it’s a bad investment, partly because of the expensive fees.
I’m a Financial Advisor: 10 Most Awesome Things You Can Do for Your Finances in 2024
8. Buy a Yacht or Second Home
Most Americans don’t have the cash to buy a boat or a second home. But having multiple residences can lessen a rich person’s tax bill.
How To Get the Deduction
If you own a home and itemize your deductions on your tax return, you can usually deduct the property taxes and the interest you pay on the mortgage. However, taxpayers have an upper limit of $10,000 ($5,000 for married taxpayers filing separately) for what they can deduct for property taxes. If you buy a second home, you can deduct the taxes and mortgage interest on that property, as well.
The IRS notes that a yacht can qualify as a home, provided it includes sleeping quarters, a kitchen and a toilet.This strategy probably isn’t practical for those who can’t afford a second home — particularly an expensive one that floats. But even if you own just one home, you should learn about the tax breaks for homeowners.
9. Open an HSA
A health savings account is a tax-deferred account that was originally designed for healthcare expenses. However, when used properly, the account can become triple tax-free.
For starters, contributions to an HSA are tax-deductible, even if you don’t itemize deductions. Next, earnings in the account grow tax-free.
Finally, distributions are tax-free if they are used for qualifying healthcare expenses,according to the same requirements as deductible medical and dental expenses on Schedule A. Distributions for nonhealthcare expenses generally trigger a 20% penalty.
There’s one additional kicker that the rich and tax-savvy can also use to their advantage: After you turn 65, you can withdraw your HSA money for any purpose at all without penalty, although you’ll still owe ordinary income tax if you spend the money on nonhealth expenses. The same applies if you become disabled.
Discover: 41 States That Won’t Tax Social Security Benefits in 2024
How To Get the Deduction
You can get the HSA deduction by opening an HSA and making contributions. HSAs are not available to all taxpayers; you must participate in a high-deductible medical insurance plan that is HSA eligible. Contributions were limited to $3,850 for individuals or $7,750 for family coverage concerning tax year 2023. They’re now $4,150 for individuals and $8,300 for families for tax year 2024.
Report your HSA contributions, calculate your deduction, report distributions and figure your HSA taxes and penalties on Form 8889.
10. Open a Solo 401(k) Plan
Most employees for larger corporations have heard of a 401(k) plan, which allows for tax-deductible contributions and tax-deferred growth of investment earnings. Those who contribute may be familiar with the annual contribution limit, which is $22,500 for tax year 2023 and $23,000 for tax year 2024.
If you work for yourself, you may think that you’re out of luck when it comes to contributing to a 401(k). The truth is if you’re self-employed, you should consider it a stroke of good fortune. Individuals can open up their own solo 401(k) plans, and they can also contribute up to a whopping $66,000 for 2023 and $69,000 for 2024.
For both plan types, an additional $7,500 in catch-up contributions are allowed if you’re at least 50 years old.
How To Get the Deduction
You’ll have to set up a solo 401(k) plan at a bank or brokerage account to get started. When you file your taxes, submit IRS Form 5500 to report your contributions.
Learn: How I Make $5,000 a Month in Passive Income Doing Just 10 Hours of Work a Year
11. Defer Income
You only pay taxes on the amount of income that you receive in any given year. Even if you complete work and are entitled to payment, if you don’t actually receive the payment until the following year, you won’t owe taxes on it until then. Thus, if you can defer receiving income even a single day, from Dec. 31 until Jan. 1 of the following year, you can wait another full year before you have to pay tax on it.
How To Get the Deduction
This is probably the easiest “deduction” of all to claim. When you defer income into a future year, you simply don’t include it in a given year’s income tax filing.
For example, if you’re due a bonus on Dec. 31 but ask your employer to pay it on Jan. 1 instead, you simply include that income on your following year’s tax return.
12. Harvest Tax Losses
U.S tax law states that you have to pay capital gains tax on profits you take in taxable accounts. Worse still, if your gains are short-term in nature, meaning you held them for one year or less, you’ll have to pay tax at your ordinary income tax rate. If you’re in the top federal tax bracket, that means you’ll owe 37% in federal tax alone on your short-term gains, according to the standards from tax years 2023 and 2024.
The smart way around this short-term gains tax is to harvest your capital losses to offset those gains.
I’m a Self-Made Millionaire: 5 Stocks You Shouldn’t Sell
How To Get the Deduction
If you have any investments trading at a loss, you can sell them, realize those losses and use them to offset your capital gains. If your losses exceed your gains, you can even write off up to $3,000 of ordinary income using those losses. In this way, a paper loss on security can translate into thousands of dollars in tax savings if you use it to offset your gains.
You’ll have to report your capital transactions on Form 8949 before summarizing your capital gains and deductible losses on Schedule D.
The wealthy might try to keep these and other tax strategies as their secrets. But, if used correctly, these tax breaks and tax loopholes can benefit everyone else in cutting state and federal taxes.
More From GOBankingRates
I'm a Bank Teller: Here Are 10 Mistakes You Are Making With Your Banking
5 Used Cars You Shouldn't Buy
Use This Checklist To See Whether Your Bank is Costing You a Lot of Money
7 Creative Sources of Passive Income to Consider in 2024
Daria Uhlig and Gabrielle Olya contributed to the reporting for this article.
This article originally appeared on GOBankingRates.com: 12 Tax Breaks That Allow The Rich To Avoid Paying Taxes
