IRS Service’s Best Kept Secret
Income tax liability is derived by multiplying taxable income by the applicable tax bracket rate. The lower the taxable income, the lower the rate, thus the lower the tax liability. Here in lies the secret to significant tax savings. Reduce taxable income, and, in turn, tax liability will be less. According to John T. Reid in his book Aggressive Tax Avoidance for Real Estate Investors (Reed Publishing: Danville, CA, 1994), the goal for tax planning is to maximize after-tax income, not minimize taxes. To maximize after-tax income, you have to reduce the income tax liability. That’s the primary goal of all tax planning. Let’s find out how this is accomplished.
WAYS TO LOWER TAXABLE INCOME.
This chapter gives you a basic understanding of the following three simple underlying concepts used to reduce taxable income:
1. Spread income over time
2. Spread income to various entities
3. Group income and expenses
Knowing something about each of these concepts will permit you to intelligently implement a sound tax program. With the assistance of a competent tax advisor, your tax savings will be significant.
Spreading Income over time
Time Real estate provides the opportunity to spread income over several years using the installment sales method of reporting. By accepting a relatively low down payment and spreading the principal payments over several years, total taxable income for any one year is reduced.
In the tax-deferred exchange method, income can also be spread over time. Both methods can be structured to give you maximum re-porting flexibility.
If you’re a real estate licensee purchasing a property and you want to spread taxes on your commissions over time, have them contingent upon some event taking place to avoid constructive receipt, if the situation warrants. For example, your commissions could be conditioned upon the property maintaining certain levels of cash flow and/or profits.
Spreading Real Estate Income to Various Entities
Spreading income to various entities reduces the income any one entity has to report. By transferring ownership of assets to corporations, partnerships, relatives, or trusts, an effective transfer of income can be accomplished as well.
Relatives in low-income brackets can be paid for services provided. As long as these services represent legitimate business transactions, spreading income in this manner can save you thousands of tax dollars.
When operating entities have dissimilar tax reporting years and basis (cash or accrual), it’s possible to spread income and expenses over different years to take advantage of the tax laws.
Grouping Real Estate Income and Expenses
Grouping income and expenses can lower taxable income. Real estate provides the flexibility to implement this kind of tax-planning tactic. More specifically, apartments do, because they fit nicely within the definition of active participation rules (which allow a $25,000 write-off against salaries and other active income). This write-off alone represents a substantial tax savings to many individual investors. See the section on this loophole on p. 167.
When changes in either income or expenses can be projected, the benefits of grouping are phenomenal. For example, refinancing will create a higher interest expense deduction to offset anticipated increases in Rental Income. Short-term loan contracts with high points will accomplish the same thing.
If expenses are projected to increase, offset them by increasing receipts from installment contracts. Avoid reporting income when notes become due by renegotiating an extension of time. If the senior mort-gage matures before your note, subordinate it to new financing to avoid payment.
Investing in midsize apartments gives you the advantage of acquiring properties outside your hometown. As a result, travel and transportation expenses related to your investments can be deducted. These deductions should be timed to give you the maximum tax savings using the “grouping method.” By rearranging the selling price and interest rate (within certain limitations), it is possible to create either higher or lower interest and/or depreciation expense deductions.
Residental Inome Capital Gains and losses can also be grouped to maximum tax benefits. With restrictions, capital losses may be used to offset capital gains plus additional amounts of ordinary income.
These represent only a few of the many techniques available. Always consult your tax advisor to assist you in making these moves.