Updated: Nov 1, 2019
Taxes are important expenses for most people and the IRS simply enforces all laws to collect them from individuals and businesses. Any type of tax mistake can affect a person or business both financially and legally. This means that understanding of taxes at all levels, federal, State and local is needed. Whether you are in business for a while or starting fresh, knowing the basics and current laws applicable to your needs, can save you money, time and stress. Utilizing a tax professional could also help you with the understanding of taxable income, tax deductions, tax credits, withholdings and perhaps, determining if you should utilize an entity.
I like to view my personal deductions as default deductions, also known as Standard Deductions. These are the deductions the IRS gives you directly. In most cases, they are preprinted on the tax forms. Many people believe that there are no such things as personal deductions. However, the wealthy know that this is not the case and do whatever is necessary to take advantage of any and all deductions.
Example of Standard Deductions vs Itemized Deductions:
John is an individual taxpayer filing as single for the year 2019. His allowable itemized deductions are as follows. John owns land in California City. His property taxes totaled $7000. He also has charitable contributions in the amount of $500. The total itemized deduction is $7,500. This is less than the Standard Deduction provided by the IRS of $12,200 as of 2019. John should use the Standard Deduction to lower his taxable income.
Commonly referred to as adjustments to income. The line refers to your adjusted gross income (AGI). Deductions that occur above the line are available to all taxpayers. Deductions that occur below the line are only available to those taxpayers who itemize their deductions. Above-the-line deductions change annually. In fact, it is not uncommon for an above-the-line deduction to either be added or renewed after the tax forms have already been printed and sent to taxpayers. It is important to know what deductions are available to you and, more importantly, how these deductions can save you money. (Remember, your tax preparer is generally aware only of what you give him or her. It is up to you to point out these deductions. The more knowledge you have regarding potential tax-saving strategies the better.)
- Educator Expenses - Student Loan Interest
- HSA Contributions - Early Withdrawal Penalties (Health Savings Account Contributions)
- Self-Employed Retirement Contributions
- Jury Duty Payments
- Certain Business Expenses (for Armed Forces reservists, qualified performing artists, fee-based state or local government officials, and employees with impairment-related work expenses)
The most common type of money-saving tax strategies for individuals are itemized deductions. Unfortunately, itemized deductions are fast becoming extinct for many middle and low income taxpayers. When you file your tax return, you can either take the standard deduction available to you or you can choose to itemize your deductions with a preset list of items the IRS allows you to deduct. Obviously, in making this determination, you want to take the method that gives you the greatest deduction.
Examples of Itemized Deductions
Deducting your medical expenses as an itemized deduction is basically a tax deduction myth. To be deductible, a taxpayer has to first itemize their deductions and their medical expenses must exceed 10 percent of Adjusted Gross Income. That 10 percent threshold takes a huge chunk out of the medical expenses you have. In most cases, this means your medical expenses are not deductible as an itemized deduction. Proper tax planning could allow you to deduct these otherwise nondeductible expenses by utilizing a health savings account or a medical reimbursement plan as a fringe benefit through a corporation.
You can deduct up to 50 percent of your Adjusted Gross Income on contributions you make to qualified charities. These contributions can be either cash or non-cash. However, the IRS is beginning to crack down on these deductions. Cash contributions need to be substantiated. A canceled check does not constitute substantiation for a contribution that is greater than $250 to any one organization in one day. Those contributions need to be substantiated in writing from the organization that receives the donation.
Household goods and clothing are an easy, effective way to generate some tax deductions that do not require the use of your cash. I would suggest accumulating these items a couple times a year and taking them to a local charity. Everyone benefits, except the IRS.
As bad as taxes can be, one good thing that comes out of them is that they can sometimes be deductible. The following taxes are deductible as itemized deductions:
- The greater of state/local income taxes or sales taxes paid
- Real estate taxes
- Personal property taxes
In states that do not have state income tax, taxpayers can deduct the amount of sales taxes the pay to state and local authorities. Just in case you haven’t saved all of those receipts, the IRS does have tables that can estimate the amount of sales taxes you have paid based on your income, where you live, and the number of people in your family. If you live in a state that has a state income tax, you can deduct the greater of the income tax or the sales tax, but not both, as an itemized deduction.
Mortgage interest is deductible on your principal residence and on a second (vacation) home. Interest on a third home would be nondeductible personal interest. Home equity interest on a third home would be nondeductible personal interest. Home equity interest is generally limited to $100,000 of debt for the main and second home combined. Just because you refinance your home or take out a second mortgage does not mean the interest is automatically deductible in full. Please get advice from your tax preparer before making what could be an incorrect assumptions. Now, as of 2018, the maximum allowed deduction of these state and local deductions are up to $10,000 combined. You are no longer allowed to deduct State And Local Tax (SALT) expenses above said amount.
Points and loan origination fees are generally deductible on the purchase of a principal residence in the year the residence is purchased. This can generate large extra deductions. Generally, the amount deductible will be about 1 percent of the amount financed. If you finance $200,000 on your new residence, you will likely have a $2,000 tax deduction the first year. There are some rules to meet, just know that this could be a hidden deduction you are entitled to take.
Points and loan origination fees paid to refinance are not deductible in full the first ear. Instead, they must be spread over the term of the loan. If you refinance your home for 15 years, you can take 1/15 of the points and loan origination fees paid per year. However, if you later refinance that loan again with a different lending institution, the amount of these fees that have not yet been deducted now become fully deductible. Many taxpayers miss this deduction every year.
With the recent fluctuations in interest rates, millions of Americans have refinanced homes once, twice, or even three or more times. There are undoubtedly millions of dollars of tax deductions that have not yet been claimed. Remember, you have three years to amend a federal tax return if you discover that you missed out on some potential deductions to which you may have been entitled.
Investment interest is interest paid on borrowed money used to buy investments included stocks, bonds, mutual funds, and even real estate. One type of investment interest that is often missed is margin interest that is paid in investment accounts. Investment interest is deductible up to the amount of net investment income received. Any excess amounts can be carried over to subsequent years.
Gifts of appreciated property are a way to generate a double deduction, so to speak. Let’s say that you wanted to donate $10,000 to your local church. After analyzing your portfolio, you determine that in order to accomplish your financial objectives, you need to sell $15,000 worth of stock you purchased a few years back for $9,000. Doing so would result in a $6,000 capital gain that you would have to pay tax on and a deductible contribution of $10,000. What would happen if you simply gave the church $10,000 worth of stock? The answer is a double tax savings bonus. You still get the same $10,000 tax deduction, but you do not have to report any capital gains. Wealthy people always seek to take advantage of these opportunities. Shouldn’t you?
Example of Differences of Auto Expenses Between Sole Proprietorship and Entities:
For Example, if you are working as a sole proprietor an Auto Expense for Business purposes include driving from your place of employment to another work site, to meet with clients, or to go to a business meeting.
Driving from your home to your workplace doesn't count as a business purpose—the Internal Revenue Service says this is commuting and that's a personal expense. But if you maintain an office in your home, traveling from your home office to meet with a client or to conduct business is tax deductible.
The deduction for business use of a vehicle is taken on Schedule C if you're self-employed, on Schedule F if you're a farmer.
As an Entity you must determine the deduction for vehicles it owns based on actual operating expenses. The corporation is also limited by the business-use percentage of the vehicle.
The corporation can deduct all of the operating expenses of the vehicle without regard to the business-use percentage, if the personal-use percentage is treated as income to the employee. This is typically the case when you get the use of a company car as an employee benefit. The corporation's deduction for the personal-use percentage is treated as a compensation expense. The employee's income for personal use of a corporate vehicle is determined based on the market value of the vehicle, not on the actual or standard method used to determine the deduction of the cost to rent a vehicle.
Examples of Accelerated Depreciation/Double Declining Method:
An accelerated depreciation method or a double declining method is a way to take bigger write-offs in the years right after you purchase a business expense. This means that your depreciation write-off starts out high, but lowers each and every year. An example would be an automobile. The IRS allows a vehicle to be depreciated over a 5-year recovery period.
You bought a $30,000 car for your business and you want to use the double declining balance method.
The first step would be to divide the cost of the truck by 5 years. 30,000/5=$6000
The second step would be to find the depreciation rate for the vehicle. 6,000/30,000=0.2 0r 20%.
The third step would be calculating the book value of the truck. You have to subtract the amount you depreciated over the previous years from the book value. In this case since it is the first year it will not change. 30,000-0=$30,000
The fourth step will calculate how much will be depreciated. (2x0.2) x (30,000) =$12,000
$12,000 is the value that will be depreciated for the first year. This number will change every year.
Tax credits are the best type of tax savings. A credit is a dollar-for-dollar savings. If you are entitled to a $1,000 credit, you save $1,000 on your tax bill. If you receive a $1,000 tax deduction your tax savings is based upon your incremental tax rate. If you are in a 25 percent tax bracket, your tax savings would be $250 on a $1,000 tax deduction. So as you can see, tax credit can be huge.
Other Personal Tax Planning Strategies
When it comes to personal tax planning, there may be no better tax shelter than owning your own home. In fact, many wealthy families use their personal residence as a wealth-building vehicle. Selling your personal residence at a gain may very well be the single, largest source of tax-free income for those taxpayers who qualify. That’s correct. These gains can be tax-free.
A single taxpayer can exclude up to $250,000 of gain from the sale of a personal residence if the individual owned and used the home as a principal residence If the individual owned and used the home as a principal residence for at least two out of the five years prior to the sale. Married taxpayers may be able to exclude up to $500,000 of gain from the sale of their personal residence. This exclusion applies to only one sale every two years.
One thing you will find is that tax considerations are always on the mind of the wealthy. Adopting this mindset can make you money. Decisions as to when to go house hunting become even more important. Doing so few months too early could cost you big bucks in tax savings. Make sure you understand the rules and make sure you have consulted your tax advisor when planning on utilizing this powerful tax saving strategy.
There is also tax planning involved in transferring assets from generation to generation. While I do not intend on going through a detailed estate planning scenario here, I do want to point out the difference between receiving assets through inheritance versus simply transferring or gifting assets before death. Many taxpayers do not handle these situations properly which ends up costing them thousands of dollars in taxes, even with a small estate.
Let’s take a look at how this information can help us. Assets that are gifted are received at the donor’s (person doing the gifting) basis. Inherited property is received with a basis equal to the fair market value (FMV) of the asset at the date of death. For example, let’s say your parents want to get a rental property they own out of their name and into yours in order to make the transition after death easier. So, they go through the motions and actually transfer title of the property into you name. Let’s say that the property was purchased 25 years ago at a cost to your parents of $20,000. Today it is worth $150,000. In this scenario, your basis in the property is the basis your parents had, $20,000. After their death, you decide that you really don’t want the hassle of keeping up with the rental property so you sell it at fair market value, or $150,000. Set up in this manner, you now have a taxable gain of $130,000 ($150,000 FMV less $20,000 basis).
Now, however, let’s assume that your parents did not transfer title of the property to you during their lifetime. Instead, you inherited the property at your parents’ death. Under this scenario, your base is now $150,000. You sell the property at FMV, $150,000. You have no gain and therefore pay no tax on this transaction. In fact, you very likely have a loss due to the closing costs incurred upon the sale.
This example can work with real estate, stocks, investments, and even collectibles. Please consult competent tax advisors when planning your estate or the estate of your parents. I guarantee you they will more than pay for themselves. While we have certainly not covered every imaginable scenario available for reducing taxes, you should understand that there are indeed ways to pay less of your money out in taxes.
A Tax Note from Abraham
The fact is, you don’t have to be scared of the IRS. Americans have every right, some would say a duty, to pay as little tax as legally possible. Speaking for the Supreme Court, Justice George Sutherland wrote:
“The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes,
or altogether avoid them, by means which the law permits, cannot be doubted.”
(Gregory v. Helvering, 293 U.S. 465; 55 S. Ct. 266; 79 L. E.d. 596)