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The rich use some unique tax strategies, but you might be able to benefit too. Read on to learn how.
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Have you ever heard that multi-billionaire Warren Buffett pays a lower federal income tax rate than his secretary? It’s true. And he isn’t alone. Many ultra-wealthy American households pay surprisingly low effective federal income tax rates, and in some cases, no taxes at all. They accomplish this (legally) by using some of the most effective tax breaks available in the U.S. tax code.
The best part is that you can learn from many of these and apply them to your own life. No tax breaks are designed to only benefit billionaires.
Eight ways the rich avoid taxes
I won’t keep you in suspense. Here are eight ways the wealthiest Americans reduce their tax liability — or even avoid paying taxes altogether.
But here’s a key concept to keep in mind. These strategies and tax breaks aren’t exclusively available to the ultra-wealthy. Everyday Americans can (and do) benefit from these as well.
1. No taxes on unrealized capital gains
The No. 1 reason most billionaires pay a surprisingly low amount of taxes is because many don’t have much income at all. Instead, their wealth is tied up in stock and other assets. Under U.S. tax law, you don’t pay any tax on investment gains until you sell, no matter how much they’ve gone up. This is known as unrealized capital gains and can be a great tool to defer taxes on winning investments in your brokerage account.
2. Charitable deductions
How does Buffett pay a lower tax rate than his secretary? The answer is he donates billions of dollars’ worth of Berkshire Hathaway stock to charity every year, and as he’s entitled to do, claims some of these donations on his taxes. This effectively cuts his taxable income in half. While you and I are unlikely to have a charitable deduction equal to half of our income in any given year, taxpayers who itemize can certainly get a nice break for their generosity.
3. Long-term capital gains rates
Billionaires generate a disproportionate amount of their income from investment income — both in the form of capital gains from investments they sell and dividend income they receive from their stocks. Profits from investments held for more than a year, as well as most dividend income, gets taxed at significantly lower rates than ordinary income.
4. IRAs
There’s one particularly notable story of billionaire Peter Thiel who opened a Roth IRA and put shares of the company that would eventually become PayPal in the account. The account ended up being worth $5 billion and because of the tax-free nature of Roth IRA withdrawals, Thiel won’t have to pay a dime in taxes on anything he withdraws from that account.
5. Pass-through income
As part of the Tax Cuts and Jobs Act, which went into effect in 2018, pass-through income (such as from an LLC or partnership) gets a 20% tax deduction. Many wealthy individuals are business owners, so they benefit from this, but it also applies to pass-through income from small businesses and self-employment income as well.
6. Tax breaks for homeownership
Homeowners get some extra tax breaks, specifically the ability to deduct mortgage interest and property taxes if they itemize. Now, there are certain instances of wealthy people stretching this a bit, such as deducting the interest on a yacht loan because it technically meets the definition of a second home. But the mortgage interest tax break saves millions of everyday Americans money every year.
7. Medical expense deductions
Taxpayers who itemize can deduct medical expenses that exceed 7.5% of their adjusted gross income (AGI). There are confirmed reports of people successfully using this to deduct expensive swimming pools as a “therapeutic” device, but the deduction can be used by anyone who has high medical costs.
8. Real estate investing tax breaks
Real estate investments benefit from a ton of tax breaks, including a big one called depreciation. In a nutshell, if you buy a rental property, you can deduct a portion of the price you paid for the property every year on your taxes. In many cases, this makes profitable rental properties show a loss for tax purposes.
When in doubt, ask for help
As a final thought, it’s very important to mention that there’s quite a bit of gray area in these (and many other) tax strategies. So, if you aren’t sure whether a certain deduction or credit applies to you, it’s a smart idea to seek help from an experienced tax professional who can evaluate your unique situation.
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