Everyone is screaming about the new, profitable tax loophole! However, there seems to be a misconception about what exactly a tax loophole is. For the most part, these are not Houdini tricks to avoid paying taxes; they are simply legal ways to reduce your taxable income to take advantage of the tax code instead of falling victim to it. Most of the “loopholes” being touted are simply underutilized deductions or strategies that are beneficial to use in filing your tax return.
Business
Individuals are taxed at the highest rates and offered the least amount of deductions. However, businesses are treated considerably better by the Internal Revenue Service. This one of the best “loopholes” you can utilize.
By creating a business, you can create an additional stream of income that is taxed at a considerably lower rate. Individuals can pay close to 50% in taxes, depending on their income and tax bracket. The income tax percentages range from 10% to 35%. However, most people also have to pay social security tax, which is 12.4% (half paid by employer) and Medicare tax, which is 1.45%. Business income is not subject to social security or Medicare taxes. As a sole proprietorship, the business is taxed at your personal rate; however, the taxable income is dependent upon expenses of the business as well.
Businesses are allowed deductions that are not available to individuals. As an individual, you earn a certain amount of money at your job. You are taxed on this amount, after very few deductions are considered. However, for the most part, you are taxed on the amount of money you earn and live on what is left. Businesses, on the other hand, earn money, are allowed to pay expenses, and then are taxed on the amount left. While, as an individual, it does not matter how much you spend in groceries or on your car payment when tax time comes, as a business, those expenses (if deductible) reduce the taxable business income.
Real Estate
This is another prominent avenue of tax breaks. Although there are not as many available as there once was, there is still a lot of opportunity to reduce your tax liability using real property.
First, it is important to note that income from real estate investments is not subject to social security or Medicare taxes. This is an automatic 13.85% of tax reduction. However, this is just the beginning.
Income from real estate is generally considerable passive income. In 1986, some serious changes took place in the tax laws in regards to passive income. It was at that time that passive income was no longer allowed to reduce your earned income. However, you may still claim up to a $25,000 reduction in your non-passive income if your income is below $150,000. There are a lot of deductions available in regards to real estate investments, so it is not necessarily difficult to have a paper loss on this form of investment.
There is also a way to avoid paying capital gains taxes on the sell of real estate by using a 1031 exchange. Basically, when you sell your property, you turn around and buy another piece of property of equal or greater value and you do not have to realize the gain at that time. This can be done multiple times to avoid paying the taxes that could otherwise be very expensive.