In 2013, the media went nuts when the third richest person in the world (April 2016) stated that his secretary was in a higher tax bracket than him.
Wowza…
How on earth could Warren Buffet say such a thing?
Clearly, he must be a tax cheat. I bet he has some off shore bank accounts in Panama!
The liberals pounced on this and screamed the rich need to pay more.
The conservatives shouted the rich need to pay less!
Yet, no one mentioned that the billionaire from Omaha was simply structuring his life around the tax code.
Hell…you could say he was unpatriotic.
As Judge Learned Hand, one of the most influential judges to never sit on the Supreme Court stated.
“Anyone may so arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury. There is not even a patriotic duty to increase one’s taxes.”
Want to be like Warren?
Here’s one simple strategy to reduce your taxes and expand your net worth.
Note: I said simple; not easy.
It’s called passive income.
Check out the definition according to the IRS.gov
In my last post I showed you the paycheck of one of my employees. Let’s dig a little deeper and see what a Minnesota millennial would net after taxes on a salary of $50,000 a year while not saving a nickel for retirement.
Let’s call him Paycheck Pete.
He is single and just graduated with a “big boy” job. He rents a swank apartment in downtown Minneapolis with his roomate and leases a shiny new Audi A4. On weekends,you find him sampling new restaurants and hanging with friends at the neighborhood sports bar.
Forget saving in a 401k, it’s all about today. Who-hoo!
Passive Pia, on the other hand, decided to go a different route.
After becoming fed up with her low paying career as a graphic designer in Rochester, Minnesota she decided to take a year off to fulfill her dream of backpacking across South America.
She financed the trip by living way below her means, selling her used Honda Accord and doing 1099 side hustles to boost her meager paycheck.
One day, while hanging out in a cafe in Ecuador, she met a middle aged retiree who was living abroad.
He told her he retired early at age forty as a result of buying ten rentals over ten years and living on a modest income of $50,000 per year.
Almost all of this income was tax free. While he kept his U.S citizenship, he took 6 months off each year to live in a different country.
When Pia asked how on earth he paid little to no taxes, he told her the IRS favors passive income over paycheck income as an incentive to get more people to invest in housing and other enterprises that help America prosper.
Basically, he explained, the tax code is written to steer people into certain directions.
Want electric cars?
Offer people a tax break for buying a Tesla and the private sector will oblige.
Furthermore, the majority of the tax code is devoted to showing people how to reduce their taxes. All ya need to do is align your spending accordingly. This is one of the reasons the rich get richer.
As a result of this chance encounter, Pia set a goal to emulate his passive income real estate strategy and never work for a paycheck again.
“Imagine earning $50,000 tax free,” Pia kept thinking.
“That’s the equivalent of making $66,000 a year trading hours for dollars in a cubicle.”
After ten years of hustling, she hit her goal by age 35 and is living the life of the fellow “Ten 2 Millionaire” she met in Ecuador.
All she did was focus on buying one modest 3 BR rental a year over ten years.
It was difficult at first. Almost impossible when you consider her lack of knowledge and resources.
Eventually she prevailed and soon found that buying her third property was as simple as buying a car.
Thereafter, it began to snowball and by the tenth property, she was a pro.
Each rental was purchased at an average cost of $150,000 and rented for an average of $1,500 per month.
They weren’t fancy, but were clean and functional in average working class neighborhoods.
The tenants paid all the utilities and her only expenses were mortgages, property taxes insurance, maintenance and repairs. She self managed the properties to save even more money.
After ten years, she was averaging $50,000 cash flow each year with far less work than she ever imagined once she nailed down her system.
Let’s compare these two millennials from a tax standpoint compliments of Tax-Rates.Org.
Of course, you should never rely on an Internet site to estimate taxes. For our case study, it will do the trick.
Paycheck Pete’s Tax Return
Paycheck Pete’s tax return is fairly typical. We aren’t adding any deductions since we are looking at the big picture. All we are doing is comparing paycheck income to passive income.
Ouch! Almost a quarter of his work day goes to the tax man. Between all the various taxes, he pays almost $12,000 per year.
As I write this, a Beatles song enters my brain.
“Let me tell you how it will be
There’s one for you, nineteen for me
Cos I’m the taxman, yeah, I’m the taxman”
I wonder who complained about taxes more. Paul McCarthy or John Lennon?
Passive Pia’s Return.
Make sure you review the notes on why she only shows $909.00 in gross income-bottom of the tax return.
PASSIVE PIA PAID ZERO TAXES
Technically, she would most likely show a bigger loss since most real estate investors show a negative income due to write-offs associated with items such as mileage, car ownership, home office, travel and entertainment. Plus, bigger items like accelerated depreciation and major improvements.
The only expense we are showing in this example is this thing called depreciation. Think of it as an expense that you don’t have to pay for.
I call it the 8th wonder of the world.
We will deep dive into depreciation on a later post. All ya need to know is Pia cash flowed $50,000 after all expenses and was able to deduct $49,090 as an offset to her income.
Being that she does not trade hours for dollars (the earned income treadmill), she pays nothing towards FICA and Medicare taxes.
Worse, if she had self employment income (as she learned when side hustling as a 1099 contractor while saving for her trip), she would pay double the rate of Paycheck Pete since Pete’s employer pays one half of the FICA/Medicare burden.
Look what’s happens if we run the same $50,000 as being self employed.
This, my dear friend, is the power of passive income.
In the case of passive real estate, you can write off depreciation directly against your rental profit.
Better yet, you can write it off against your EARNED income if you are a real estate superstar and have excess losses due to all the buildings you buy and hold while working in another career-subject to limitations.
Time to circle back to Warren Buffet’s clever tax strategy. He basically implements the same system as Passive Pia.
While he pays a higher tax rate due to the tax treatment of his portfolio income and other income sources, he is squarely in a low tax bracket (compared to the typical high earning professional and fellow billionaires) since he caps his annual salary at $100,000.
The next time you look at your paycheck, imagine it showing zero deductions. Then dream about how you could leverage those tax savings into financial freedom.
Now comes the tricky part, converting your paycheck income to passive income.
We will look into that in future posts.
Further Reading:
Enjoying the blog.
I’m a newbie, so please excuse if this is a poor question.
I’m curious what you mean by: ‘accelerated depreciation’. It was my understanding that 27.5 years straight-line was the only allowable period and method, however, I do recall reading that you can segregate costs and depreciate other items (appliances, landscaping, etc.) over a shorter period. Is this what you’re referring to here?
Great question William and thanks for the comment.
As you mentioned, you can speed up the depreciation on items with a shorter useful life. Think of things like a fridge, stove, carpet, cabinets, etc. This allows you to take a bigger deduction sooner and lower your taxable income even further.
Still, the 27 1/2 year straight line method is my favorite. I know some landlords who hire out the cost segregation study and this can speed things up further. Being a buy and hold guy, I’m not really interested in this technique since I view deprecation as another way to boost my returns.
For people that only plan on holding the property for 5 years or less, the cost segregation makes sense.
Call my old fashioned, but my holding period is forever. Kinda like Warren Buffet.