How to Reduce Taxes (In the Years to Come)

How do you play the chess game of the tax code?

The tax code is highly incentivized to those who are entrepreneurial in nature. This means, investing in your business with equipment, employees, or in real estate is the #1 way to reduce taxes. Essentially, whenever you can reduce your income by a $1, you save 30 cents on every transaction. Begin to add a few zeros, and that is a lot of cash back in your pocket. But where, and in what areas, do you get the biggest bang for your buck?

1. Investing in Assets

Under § 167, you get a benefit for investing in assets and properties as a taxpayer. This comes through depreciation. Depreciation is a ‘paper’ deduction for the ‘wear and tear’ of a property used in a trade or business. And with bonus depreciation under § 168(k), business owners can take a large chunk of their investment as an expense the year of purchase.

Depreciation is the king of real estate. Depreciation can help offset the majority of rental income, allowing the cash flow from a property to be completely tax-free. Also, see Cost Segregation Studies as well, as they can be powerful for real estate investors.

2. Retirement Plans

Retirement plans and incentives are another area of the tax code that is incentivized. The tax code WANTS owners and investors to put more into retirement accounts.

Not financial advice, but sometimes taking a deduction today when maxing out a 401(k) contribution is a better tax save than contributing to a Roth 401(k) or IRA.

Why?

When you are running a business, it is far more likely that you will be in higher income brackets than when you hit retirement at 59. And, the cost of maintaining and contributing to your plan for your employees is ALSO tax-deductible for you. Some employers can even receive a tax credit for contributing to their employees’ plans.

3. Deferral of Gain

There are plenty of areas in the tax code that allow you to ‘kick the can down the road’ on your taxable events. If you sell a property, or even a business, you might be able to use a few key tools to defer your savings down the road. § 1031s are generally fantastic for those who want to stay in real estate (note that less than 10% of 1031s completely avoid a tax event). But this allows you to keep your capital in bigger and better assets, and maybe even reap the rewards of depreciation too. And, 1031s are only eligible for real estate gains in this instance. So if you sell a business or stocks, then you’re out of luck on 1031s.

Other investments that help defer gains are Qualified Opportunity Zones, rollovers (think adding assets to partnerships), and UPREITs (similar concept).
QOZs are looking to be largely expanded in the new tax legislation bill as well

Why defer gain but lock yourself into certain asset classes? I only recommend this if you plan on staying in a similar asset class and believe in its appreciation. That way, you can save today’s dollars and continue to increase your tax savings.

4. Entity Structure

Taxpayers think about this a lot, but not enough. Entity structuring is not just setting up an LLC and calling it a day.

Entity structuring requires answering multiple questions:

a. What is the cost of setup and tax compliance with this entity?
b. Does it provide enough asset protection?
c. What tax savings will it provide today, and what will it provide when I sell or exit?
d. What are my ‘selfish’ reasons for doing this?
e. What’s my audit risk

I recommend talking to an attorney on 1 & 2. But a quick rundown on 3-5.

Tax savings today are important, as they provide more cash flow today. But will it raise the cost down the road when you either exit the business or sell your real estate? I think this is something that both real estate investors and SMB owners don’t consider enough.

Sometimes paying a little extra in tax today (i.e., not becoming an S-Corporation) is more advantageous because when you exit later, your legal and compliance fees can go through the roof (talking potentially hundreds of thousands of dollars)

Selfish reasons?

How do you want cash to come out? Do you want tax losses? Do you prefer to protect yourself from your potential partners? These things are ‘selfish’ as they do attribute to a business purpose, but aren’t necessarily dependent on how the business is run. It focuses on what you, as the owner, get out of it.

Same goes for real estate. Did you invest for the appreciation? The cash flow? So the structure of the entity is important in how you get that out (also, please do not ever use an S Corp to invest in real estate)

Conclusion

Tax reduction is a fun game to play, but only those who are diligent and try to understand can really make it happen.

The biggest expense anyone has across their lifetime is taxes.

And if you want to optimize this as much as possible (and let’s not forget be sure to shore up ourselves against IRS Audits too)

Find a good advisor to work with.