Taxes will be the single largest expense in your lifetime. Each year, the average taxpayer can expect to lose 3 to 4 months of their income by paying taxes. However, it’s not all bad. The tax code is actually a roadmap to vast amounts of wealth.
Why You Need to Tax Plan
We are trained to believe that if we earn money, we owe taxes. That is not true. In fact, the tax code is designed to show you how to reduce the taxes you owe legally. There are over 5,800 pages of tax law in the United States. Only about 30 pages are devoted to raising taxes. That means nearly 99.5 percent of the tax code exists to help you pay less in taxes. All of the complexity in the tax code is devoted to lowering your taxes, not increasing them.
The best tax planning is permanent. By looking at the return on investment (ROI) of all your investments after taxes, you will learn how valuable tax planning can be. Let’s take a look at an example below.
Real Estate Tax Planning Example
Before taxes, real estate only looks like an ok investment. But after taking into account taxes and debt (leverage), it becomes an excellent investment. Let me explain.
Let’s say you purchased a $400,000 rental property with a 20% down payment. This means you used $80,000 of your own money and $320,000 of the bank’s money. Let’s also assume that the return on investment of your $80,000 is 7% per year.
Let’s also assume that you have a friend that invested $80,000 in the stock market at a 10% return per year.
So your friend clearly made the better investment, right? Nope. Let’s take a closer look at how your real estate was actually the better investment.
Your friend’s stock market investment will return $8,000 before taxes. Assuming a capital gain tax rate of 15%, that is an after-tax return of $6,800.
Your real estate investment will return $5,600 before taxes. Due to the magic of depreciation that all rental real estate is allowed to deduct, your real estate investment will return the same $5,600 after taxes. However, your after-tax return is still less than if you put your money into the stock market.
But wait, there’s more!
Deducting Losses Against Income
Each year, you can deduct about $15,000 in depreciation on this rental property. So, after subtracting your $5,600 in positive cash flow, you can deduct an additional $9,400 on your tax return.
Assuming you are in the 32% income bracket, this $9,400 deduction results in a $3,000 decrease in your tax liability.
Your real return from your rental real estate would be the $5,600 in cash flow plus the $3,000 saved on your taxes for a total return of $8,600. That is $1,800 more than your after-tax return in the stock market.
This is just one example of how tax planning can significantly impact ROI. If you had only looked at your ROI as your cash flow before taxes, you would have left money on the table and gotten stuck with a larger tax bill. Therefore, you should always consider taxes before making any investment decisions.
At Windstone Financial, we specialize in creating tax mitigation and wealth-building solutions for our small business clients. If you need help reducing your tax burden, click the button below to speak with a CPA today!