How can the type of employment determine taxation? Easy. It’s what the US government wants to encourage.
There’s a now legendary story of Warren Buffet as it relates to taxes. When interviewing Mr. Buffet, a reporter asked him what he thought about the US tax system and he quipped that he paid a lower tax rate than his Secretary. In fact, he conducted a survey in his office and found that he paid an overall tax rate of 17.7% and on average his employees paid a 32.9% tax rate.
The tax system incentivizes ownership and penalizes working for someone else
How could this be possible? Well, the truth of the matter is that the US government has set up its taxation system to incentivize asset ownership and investment and “penalizes” those individuals who have W-2 earned income from a job working for others.
More specifically, the tax rate for many middle-class W-2 earners in the US is somewhere in the 22-24% range. However, for those individuals who draw dividend income from income generating assets, the primary source of income for Mr. Buffet, their tax rate is currently 15%.
Interestingly enough more incentives are further carried through to the owners of those assets that generate dividend income. As a result, the tax code provides for a much larger tax deferment for individuals who own businesses and save for their retirement.
In fact, in 2020 a business owner under the age of 50 could contribute $57,000 annually to a Solo 401(k) versus just $19,000 for an individual working a W-2 job.
Basically the individual who would like to invest the same amount as someone who owns a business, is going to have to do it at a significant tax disadvantage. Once again, the US tax system is encouraging individuals to become employers and wealth builders versus employees and wage earners.
Business ownership is tax advantaged
As you already know from previous posts, the favorable tax treatment of business owners is further extended through the rules which allow businesses to expense business costs prior to being taxed.
Unlike individual W-2 employees who don’t get any such favorable tax treatment on their expenses, which are made from ‘net income’ after taxes are withheld, business owners who spend on items that are part of their business get to deduct these expenses from their gross income before being taxed.
So what should we wealth builders take from this? I think it’s quite simple. We really only have two options; we can spend a lifetime of paying higher taxes as a W-2 worker OR we can ‘partner’ with the US government and do what they want us to do which is to create wealth for our community and ourselves.
That’s right! We should recognize that the government wants us to be their partner in creating wealth and to take advantage of the rules by becoming an owner and an investor. The easiest way to do this is to create a for profit business.
Rental real estate is HIGHLY tax advantaged
We already know through previous posts the tax benefits that can accrue to us if we are a business owner. We also now know the tax benefits of being an investor which is the lowest tax treatment due to earning dividend income or capital gains. That all said, there is also favorable tax treatment if we were to build wealth through the ownership of rental real estate.
For starters you get to write off operating expenses similar to any other businesses, your mortgage interest for the property AND you get to depreciate the value of the structure over 27.5 years. This effectively lowers the tax exposure you have against the income you earn on that property by acting as a “loss” against the income you receive in that year.
The term that is applied to this is a “phantom loss” because you technically didn’t lose anything, especially if the property positively cash flow (which it has to if you’re a wealth builder!).
The phantom loss helps you make big gains
This “phantom loss” goes even further as the IRS says that you can take up to $25,000 in real estate losses (‘phantom losses’) should your modified adjusted gross income (MAGI) be less than $100,000.
Above that income level it is prorated then eventually eliminated. However, the BIG advantage for those whose MAGI is less than $100,000 is that this loss can be transferred over against their earned income in a W-2 job.
Please understand what that just said…As a W-2 earner, someone who works for someone else, there are next to NO tax advantages beyond someone’s standard income deductions at the end of the year. For the most part, W-2 earners are paying the full freight within their tax bracket. However, with a MAGI of less than $100,000 rental property owners can use this ‘phantom loss’ provision to cover income that was earned in their W-2 job. WOW! That’s huge.
How would you like to pay NO income tax?
The bottom line is that real estate is perhaps the most tax advantaged asset available. Using the above premise there are literally scenarios where you wouldn’t even have to pay tax on the income your rental property generates! Let me take a shot at this.
As an example, let’s assume that after you deduct your operating expenses and interest on your mortgage you are left with $3,500 in net cash flow for the year. If we now apply our depreciation on our real property, the ‘phantom loss’, which we have calculated to be $5,000 a year we would have effectively wiped away any rental income that needs to be subject to taxation. In fact, we have a $1,500 ($5,000 – $3,500) left over ‘loss’.
But the hits don’t stop coming, as they say, that $1,500 ‘loss’ is allowed to be applied against other earned income if our MAGI is less than $100,000. So technically we got to eliminate all our income from our rental property from taxation and by being able to have a leftover ‘loss’, we were able to cover some of our W-2 earned income from taxation. What a deal!
Let’s take this further what if we multiplied this example by a factor of 10 where we now owned 10 properties that did the exact same thing for us?
Beyond the fact that all of our real estate income would be eliminated from taxation we would now have a residual $15,000 ($1,500 x 10) of ‘loss’ that we could apply against our W-2 earned income!
Applying some fictitious figures back into the above example we could theoretically then have an annual gross rental income of $60,000 (10 properties generating $1,500 gross rent a month or $6,000 a year) from our rental properties that gets completely shielded from taxation.
YOU pick how much you’re taxed
Most people I counsel bemoan the taxation situation and feel that they are somehow ‘victims’ and there’s not a thing that they can do about it but complain loudly. I see it totally differently.
Knowing what I know now, WE…you and me…are in control of how we want to be taxed when we decide what role we choose in earning our income.
If we choose the role of wealth builder then we invariably choose to be taxed at a lower rate as we earn our income. If we choose to be a W-2 earner, then we invariably choose to be taxed at the highest rate.
It’s just that simple.
