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Slash Your Taxes

The Approved Guide to the Best Tax Deductions Allowed

A Publication of Newsmax.com and Moneynews.com

The Moneynews Financial TeamAndrew Packer, Editor

Slash Your Taxes Special Report

Slash Your TaxesThe Approved Guide to the Best Tax Deductions Allowed

[ CONTENTS ]

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3Chapter One: Getting Ready for Tax Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5Types of Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5Itemized Deductions vs. Standard Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8Capital Gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10Tax Deductions vs. Tax Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14Chapter Two: Three Key Principles of Tax Avoidance . . . . . . . . . . . . . . . . . . . . . . . . . . . 15Tax Deferrals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15Shifting Investment Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16Shifting Tax Brackets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16Chapter Three: Tax Deferral Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17Income Deferment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17Tax-Efficient Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18Harvesting Losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20Tax-Deferred Retirement Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22Chapter Four: Shifting Investments From Short Term to Long Term . . . . . . . . . . . . . . . . . . . 26Dodging the Sinister Tax Straddle Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27Borrowing to Avoid Short-Term Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28Saving 12 Percent Is Easy as 1-2-5-6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29Chapter Five: Using Family, Businesses and Gifts to Lower Your Tax Burden . . . . . . . . . . . . . . . 32Gifts That Keep On Giving. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32The Benefits of Owning a Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34Gift Giving for Minimizing Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42Conclusion: Doing the Right Thing to Minimize Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . 43

Special Report Slash Your Taxes

Death and taxes are two of life’s certainties, but with one profound difference: As Will Rogers put it, “Death doesn’t get worse each time Congress meets.”

Since 1962, the U.S. debt ceiling has been raised 74 times: George W. Bush raised it seven times, Bill Clinton eight times, and Ronald Reagan 18. And Barack Obama has raised it seven times — so far. Death has boundaries; Congress doesn’t.

In 2011, the government spent 55% more than it collected. In 2012, the Senate voted to further increase the debt limit, allowing Obama to borrow another $1.2 trillion. Two years later, in 2013, the Treasury announced if the debt ceiling is not raised again, the U.S. would default on its debt by October. With spiraling out-of-control government spending, another trillion dollars may last till Tuesday. It’s all leading to one thing — increased taxes.

You can be sure the government is not targeting the super-wealthy and large corporations. Politicians need their financial support. It’s not going after the indigent and poor; they have no money. There’s only one target left — you. Uncle Sam is aiming to increase your taxes. Count on it.

But just because the government is aiming for you doesn’t mean you have to pay more taxes. While you cannot escape death, you can avoid being taxed to death.

In this guide, your Newsmax team of financial experts will show you how, by uncovering three key principles the wealthy use to reduce taxes to almost nothing. Now, don’t think you need an oceanfront mansion, Rolls Royce or private jet to make these strategies work. It’s about using tax laws to your advantage and reducing taxes to nearly nothing. “Nearly nothing?” you ask. “Isn’t that illegal?”

This guide is not about tax evasion — that’s illegal. Tax evasion is any means of hiding money from the government through offshore accounts or sophisticated asset protection plans so the money cannot get taxed. Those plans ultimately fail. And when they do, you can add another thing to the list of life’s certainties — jail.

This guide is about tax avoidance, which is the common, legal practice of all businesses and people wishing to reduce taxes and put more money their pockets. It’s just the term that economists, accountants, and other financial professionals use to describe any legal tactic that reduces taxes.

Chances are, you’ve engaged in tax avoidance and just didn’t know that’s what it was called. Did you ever itemize deductions because it lowered your taxes compared to taking the standard deduction? Did you find that more than one filing status applied to you and selected the one that yielded the lowest taxes? Those are simple methods of tax avoidance.

Economist John Maynard Keynes said, “The avoidance of taxes is the only intellectual pursuit that still carries any reward.” So don’t think of April 15 as tax day; think of it as payday.

By using the three key principles of tax avoidance elaborated in this guide, the wealthy pay almost nothing, making the tax system seem unfair.

For example, during the 2012 election campaign, there was a lot of publicity over the fact that Republican candidate Mitt Romney earned $13.7 million in 2011 — but his tax rate was only 14%. Have you ever paid 14% or less in taxes — ever? And you probably earned a whole lot less too.

Introduction

The avoidance of taxes is the only intellectual pursuit that

still carries any reward.


To add fuel to the controversy, while Romney’s taxes were being dissected by the media, it was discovered that Warren Buffett’s tax rate was 17.4% while his secretary paid 35.8%. How could a multibillionaire — to the tune of about $60 billion — pay less than half the rate of a W-2 salaried employee? Because he uses every tax avoidance tactic he can.

Maximizing the Value of this GuideWhile this guide does provide specific tactics and touches on certain laws, it’s never a good idea to

write a guide specifically about current tax laws. They’ll be outdated before the ink dries. Tax laws are complicated, and get more complex each year. The 2013 tax code takes nearly 74,000 pages to explain the intricacies.

Instead, you can sharply reduce your taxes — sometimes to nothing — by understanding three key principles that have always been the foundation of all tax avoidance strategies. Current laws will change the amounts you’ll save, but the strategies are essentially the same. You’ll always understand how to manage your finances to minimize taxes.

However, unless you are highly trained in preparing taxes, we strongly recommend using tax advisers, whether certified public accountants (CPAs), enrolled agents (EAs), or tax attorneys. Let them keep up with laws and the details. They use sophisticated software that can find the best mix of tax-saving strategies for you — provided you ask the right questions.

It’s well worth the price to find a good tax preparer, especially one who understands today’s new business models. Fewer people are W-2 wage earners and more are becoming 1099 contract employees. People now tend to hold portfolios of jobs rather than just one steady position. Times have changed. And unless your tax adviser understands these changes, you’re probably going to pay more taxes than necessary.

If you understand the three key principles outlined in this guide, you’ll be better equipped to ask your tax adviser intelligent questions and keep track of relevant information throughout the year that will save you money at tax time.

So if you’re ready to avoid being taxed to death, let’s find out how you can make the most of your money — by paying the least in taxes.

Aaron DeHoogFinancial PublisherNewsmax and Moneynews.com

Introduction


In April 2013, Apple (AAPL) was hoarding $145 billion in cash, yet announced it would borrow over $17 billion, making it the first time in nearly 20 years the company borrowed money. It was also the largest corporate bond issuance in history. It was an intriguing announcement. Why borrow money — and pay interest — when the company’s sitting on $145 billion cash?

Apple was under increasing pressure to distribute some of its cash hoard to shareholders. In February 2013, hedge fund manager David Einhorn even filed a suit against Apple, saying it was too conservative with its cash because it nearly went broke in the 1990s; the company had a duty to distribute more of its cash to shareholders.

In response to the public pressure, Apple announced plans to pay out $60 billion to shareholders by the end of 2015 through a share buyback program plus a 15% dividend increase to $3.05 per share.

Sure, Apple could easily have used some of its $145 billion to meet this future financing. But there was a slight problem — over $100 billion was held overseas. For Apple to repatriate the cash, or “bring the dollars home,” would trigger a tax consequence of a staggering $35 billion. Nobody wants to pay that — not even Apple with more than enough cash to easily foot the bill. Was there a way to avoid the tax?

Yes. Apple borrowed $100 billion to create the cash necessary for the stock buyback program and pay dividends to shareholders — but saved over $9 billion in taxes. The good news didn’t stop there. The interest on the loan is also tax deductible, which will save the company another $100 million per year.

For Apple, the decision was easy: It was cheaper to pay the interest, and deduct it, than to pay the taxes. It was a brilliant tax avoidance plan and one of the key reasons the rich get richer.

When the media presents numbers like these, the system does seem to favor the rich and powerful. But never forget one thing: You operate from the identical tax codes as Romney, Buffett, and Apple. You just need to understand their tactics.

Without increasing your salary, increasing your education, or increasing your skills, you can immediately earn more money just by following simple

tax avoidance techniques — and that’s what we’re going to show you in this guide. Taxes represent the largest expense for everyone. Reducing them is the fastest way to keep money in your pocket.

Reducing Taxes Is One Huge Boost on the Road to Wealth

For all financial planning, taxes must be considered; unfortunately, they are the most overlooked. Too many people focus on return on investment, gross income, gross returns, and other measures rather than net after taxes.

A job paying $1 million per year may sound great, but if it’s taxed at 99%, you’ll be better off bagging groceries. It’s not what you make that counts; it’s what you keep. Taxes matter; they determine the profitable part of the puzzle.

Real estate is another great example. It’s true that stocks have outperformed real estate in total returns — but that’s not counting taxes. Stock investing means you’ll usually pay 20% or more in capital gains. With real estate, however, you can depreciate the capital gains, and it also reduces your taxable income — saving you more in taxes.

If you consider taxes, you’ll see that real estate can actually double the dollar returns to you, at least based on today’s tax structure. This isn’t intended to persuade you to invest in real estate but, instead, to show why you can’t just look at raw numbers or percentages to make good financial decisions. You must consider taxes. And if you understand how to reduce them by using the three key principles of tax avoidance, you’re on your way to earning more money.

Types of Income The tax codes define income as all money paid to

you from whatever source derived. That’s a pretty clear definition; there’s not much wiggle room for interpretation. If you received money, chances are it’s taxable. Does this mean that illegal gains are taxable?

Surprisingly, yes it does. Tax laws used to read that lawful income was taxable. However, in 1916, the word “lawful” was removed from the tax codes. So

Getting Ready for Tax SavingsApple Takes a Bite Out of the IRS

[ CHAPTER ONE ]


bribes, kickbacks, and stolen goods are all reportable under “other income” on Line 21 on Form 1040, or on Schedule C or Schedule C-EZ (Form 1040) if you are self-employed. If you don’t report it, you may end up in jail.

In fact, American gangster Al Capone was not sent to federal prison for bootlegging; he landed in the slammer for not reporting his illegal activities on his taxes. So it wasn’t a security camera, shootout, or snitch that sent Capone to Alcatraz. It was tax evasion.

Of course, reporting millions in ill-gotten gains doesn’t mean you just go on your merry way and begin spending the loot. You’ll get reported to the appropriate agencies, which means there’s a price to pay. But at least it won’t be tax evasion.

You may think money is money, but the IRS classifies money according to how it’s earned. Generally speaking, you have three categories: earned income, unearned income, and portfolio income.

Earned income is any income derived from wages, salaries, bonuses, commissions, and other common payments received for providing labor.

Unearned income (also called passive income) is any money earned but by not directly participating. The IRS says that passive income comes from two sources: rental activity and any trade of business where you do not materially participate, such as being a silent partner.

The third category is portfolio income (also called investment income), which comes from interest, dividends, capital gains, and royalties. Portfolio income is usually taxable. If you have a checking account that pays interest, or own shares of stocks that pay dividends, they are taxable.

Capital gains are in class of their own. A capital gain occurs whenever you sell an asset, whether shares of stock or a baseball trading card on eBay, for an amount greater than you paid. If you sell an asset for less than you paid, you have a capital loss. Because capital gains can be relatively large, they are a key area for tax avoidance.

Sometimes you’ll see the term ordinary income, which is a broader category covering all types of income except capital gains.

One of the key imperatives for understanding

earned income versus unearned income is that many tax deferral strategies depend on contributions to tax-advantaged accounts such as individual retirement accounts (IRA) or 401(k) plans. You may only contribute to these plans if you have earned income. You could make millions in dividends each year but not be able to contribute to a tax-advantaged account unless you have earnings.

Solving the Mystery of Marginal Taxes

The U.S. tax system is a progressive income tax system, which just means the more money you make, the more

Uncle Sam takes. Your tax bill progresses with income.

Many tax avoidance tactics rely on transferring income to lower tax brackets, so that money is taxed at a lower rate. By understanding tax brackets, especially the marginal tax rate, you’ll be able to quickly calculate the savings from any given strategy and determine if a

particular action is worthwhile.Tax brackets are outlined each year in the tax codes

but remain fairly stable from one year to the next. The amount of tax you owe depends not only on your income, but also on the filing status you select when filing your taxes. You have five choices, but if more than one filing status applies, you would select the one that yields the lowest taxes:

Rate SingleMarried

Filing JointlyHead of

Household

10% $0 - $8,925 $0 - $17,850 $0 - $12,750

15% $8,925 - $36,250 $17,850 - $72,500 $12,750 - $48,600

25% $36,250 - $87,850 $72,500 - $146,400 $48,600 - $125,450

28% $87,850 - $183,250 $146,400 - $223,050 $125,450 - $203,150

33% $183,250 - $398,350 $223,050 - $398,350 $203,150 - $398,350

35% $398,350 - $400,000 $398,350 - $450,000 $398,350 - $425,000

39.6% $400,000 and up $450,000 and up $425,000 and up

Table 1: 2013 Tax BracketsThree of the most popular filing statuses along with tax rates, or brackets, and their associated income ranges:

If you later find that a different filing status would have yielded fewer taxes, you can file an amended return, but you must do so within three years of the original filing.


• Single• Married filing jointly• Married filing separately• Head of household• Widow(er) with dependent child

For 2013, we have seven tax brackets, including a brand new 39.6% bracket for the top earners. Regardless of how many brackets, the idea is to show various income ranges and the amount of tax owed at each level.

To understand Table 1, just consider single filers. If you earn up to $8,925, you’ll owe 10% of that amount as income tax. Keep in mind that these brackets only apply to federal taxes; most states assess income taxes too. Only seven states have no income taxes: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.

However, as shown by the row at the 15% rate, if income is between $8,925 and $36,250, single filers owe 15% to Uncle Sam.

It’s this progressive tax structure that causes confusion for many taxpayers. Most believe if they earn $8,925 they’ll pay 10% and therefore should not accept a single dollar more in taxable income since it kicks them into the 15% bracket. But if your income increases by one dollar from $8,925 to $8,926, it does not mean you pay 15% on all your income. Your tax bill would not be 15% of $8,926, or $1,338.90.

Instead, it’s just that single dollar above $8,925 that’s taxed at 15%. If you earn $8,925 and accept one more dollar in taxable income, your tax bill increases by only 15 cents.

Only those dollars earned between $8,925 and $36,250 are taxed at 15%. The first $8,925 is always taxed at 10% regardless of how much you earn.

The additional percentage of tax owed for one more dollar of income is called the marginal tax rate. The word “marginal” just means extra or additional, so it shows the additional tax owed from earning the next dollar.

The important point to understand is that the progressive tax system will never leave you with less money because you entered into a new tax bracket. That would be a terrible tax system as nobody would have the incentive to earn more money.

Bottom line, if you pay more taxes, it’s because you earned more money. So if anyone asks if you’d like to

pay more taxes, the answer should really be yes!Many tax strategies we’ll cover allow you to reduce

your taxable income by taking deductions. To figure out if it’s worthwhile, all you have to do is work Table 1 in reverse. If you are a single filer earning $50,000, how much will you save in taxes if you take a $10,000 deduction? The table shows that earning $40,000 keeps you in the 25% bracket, so a $10,000 reduction in taxable income saves 25% of $10,000, or $2,500 in taxes.

While tax rates are bad today, especially with the new 39.6% bracket, they have been much worse. The highest marginal rate for the United States was 94% in 1944, and the greatest number of brackets was 32 in 1941.

But even back then, tax avoidance strategies were based on the same principles. The nation has had a progressive tax system since Abraham Lincoln signed the Revenue Act of 1862; as long as this system remains, tax avoidance strategies will survive regardless of the number of brackets or the highest marginal rates.

It’s Good to Fall Below AverageTable 1 shows you’d fall in the 25% tax bracket by

earning $40,000. But that doesn’t mean you’d pay 25% of your income in taxes. Some money is taxed at 10%,

some at 15%, and the remainder at 25%. Your average tax rate is therefore much less than 25%.

The average tax rate is just the total tax paid, divided by your income. It’s important to know since many people feel that tax strategies don’t work unless they

shift you to a lower bracket. As long as your average tax rate falls, you’re saving money.

To find the average tax rate, you first have to find your total tax. If you earned $40,000, your total tax bill would be $5,928.75. Here’s how it works:

You’d pay 10% for the first $8,925, or $892.50. Because you earned more than $8,925, you must step up to the 15% bracket. The upper income range for the 15% bracket is $36,250, so you’d have $36,250 - $8,925, or $27,325 taxed at 15%, or $4,098.75.

However, you earned even more than the $36,250 upper end of the 15% bracket. So those dollars are taxed at the next highest rate of 25%. You have a $40,000 salary less $36,250, so only $3,750 is taxed at 25%, or $937.50. Your total tax bill is the sum of these three calculations, or $892.50 + $4,098.75 + $937.50 = $5,928.75.

If your total tax is $5,928.75, your average rate is

Shifting to a higher tax bracket never leaves you with less money.


$5,928.75/$40,000 = 14.8%. On average, it’s as if you paid a lump sum tax of 14.8% on your entire $40,000 earnings.

Most of the low tax percentages you read about the wealthy paying refer to average tax rates. When Warren Buffett said he paid 17.4% taxes, that’s not his tax bracket, nor will it ever be. It’s his average tax rate. You can be sure that’s a lot less than his marginal tax rate, which will always be in the highest bracket.

So while marginal tax rates may seem high, it’s the average tax rate that matters most, and it will always be less than the marginal tax rate. The exception is for those who are in the bottom 10% bracket; their marginal rate and average rate will always be the same.

The main point to understand is that if tax strategies don’t drop you to a lower marginal tax bracket, it doesn’t mean they don’t work. They’ll greatly reduce your average tax rate. And the average rate is all that matters. When it comes to taxes, it’s good to fall below average.

Alternative Minimum Tax (AMT)Just in case you find the perfect mix of strategies to

reduce your tax liability to nothing, the IRS has laws to ensure they’ll get something from you. These are the alternative minimum tax (AMT) laws, which are a second set of rules, or parallel tax system.

The first version of the minimum tax was introduced in 1969, and was known as the millionaires’ tax since it was designed to target those who can whittle their tax liabilities down to nothing. Later, it was changed to include more exemptions and deductions and evolved into its present form in 1982.

The AMT excludes standard deductions, personal exemptions, and certain itemized deductions. All good tax accounting software will evaluate tax liabilities using standard methods and then calculate another figure based on AMT. The taxpayer must pay the greater of the two amounts.

One of the exasperating things for taxpayers is that AMT was never indexed to inflation when it was created. So each year, the government has to pass new laws to raise the applicable income levels. If it didn’t,

nearly everyone would be subjected to AMT, and it was really designed to target the wealthy. The AMT laws are challenging because you never quite know how to prepare for them, or how they will affect you, until the new limits are announced.

In 2013, President Obama signed the American Taxpayer Relief Act of 2012, which increased the income levels subject to the tax. For 2013, AMT applies to anyone making more than $51,900 (single) or $80,800 if married or filing jointly.

The AMT is yet another reason to take every legal tax break you can. It’s hard enough to plan your tax strategies, but when you’re faced with ever changing, unknown AMT rules, you can’t wait for the announcement and make your plans. But as a guide, AMT will likely come into play if you:• Have many children (each provides a $3,800

exemption not allowed under AMT)• Live in high income tax states such as California or

New York• Have many itemized deductions• Have large medical deductions• Received employee stock options• Paid substantial interest on a home equity loan but

didn’t use the money to improve your home or buy a second one

Itemized Deductions vs. Standard Deduction

Each year you file taxes, you can deduct certain expenses from your income. The IRS recognizes there are probably small daily deductions that are too time-consuming to track, so it offers a standard deduction; it’s an automatic tax break available to everyone courtesy of Uncle Sam. The amounts usually change slightly each year, mostly to account for inflation. For 2013, individuals may deduct $6,100, while married taxpayers filing jointly may deduct $12,200.

However, you can choose to itemize your deductions. This means you must list each deduction, which is done on IRS Schedule A. If you itemize, you waive the standard deduction. Most accounting software or professional tax preparers will do both and you simply take the one that offers the biggest deduction.

For most people, especially homeowners, itemizing is usually the best alternative, but it’s annoying to keep up with all of the receipts. About 70% of all taxpayers take the standard deduction, mostly for simplicity. But convenience has a big cost…

Tax Bracket Dollars Taxed Total Tax

10% $8,925 $892.50

15% $36,250 - $8,925 = $27,325 $4,098.75

25% $40,000 - $3,750 = $3,750 $937.50

Grand Total = $5,928.75


According to a 2002 Government Accountability Office (GAO) report, about 2.2 million taxpayers overpaid by an average of $438, costing taxpayers nearly $1 billion. The most overlooked areas were mortgage interest, loan points, property taxes, state and local income taxes, and charitable donations.

Taxpayers often miss these key areas, especially charitable donations. Too many people incorrectly believe that giving to charity means you just give it away without benefit. Not true. It can be a powerful tax strategy, especially if you’re looking for last-minute deductions. In 2005, Vice President Dick Cheney deducted $6.8 million in charitable donations – and netted a $2 million refund as a result.

In 2011, Ronald S. Lauder, heir to cosmetics mogul Estée Lauder’s fortune, donated his rare art collection worth nearly $1 billion. However, he donated it to his private foundation. He still owns the art, but saved hundreds of millions in taxes.

If you rush to get your taxes done each year, there’s a good chance you’ll end up taking the standard deduction. With today’s technologies, many cellphone apps will scan receipts, track car mileage, and other things you may be able to deduct. Most people would benefit from itemizing even though most choose the standard deduction for convenience. That can be costly. If you’re truly interested in reducing your taxes, you must become tax efficient — and that means organized.

Cost BasisWe’ll show many tax-saving strategies for your

investment income, or portfolio income, such as stocks, bonds, and mutual funds.

To understand the benefits, you’ll have to understand a few basic investing tax terms. The first is the cost basis. At its simplest definition, the cost basis is the amount you paid to acquire an asset. However, the law also allows the cost to adjust, which makes the cost basis more complicated than the outright purchase price.

For example, the cost of getting assets up and running can be included in the basis. If you buy a new office computer system for $10,000 but pay a technician $2,000 to install it, your cost basis is $12,000. If you pay someone $3,000 to train you and the staff, your cost basis increases to $15,000. If you had to pay for a special license to operate particular equipment, that gets tacked on to the cost basis as well.

The cost basis can get tricky for shares of stock or other financial assets. If you buy 100 shares of Amalgamated Gizmos for $100 per share then that’s the cost basis — at least for now. The $100 cost basis can be adjusted for splits, mergers, and other corporate actions. If the company does a 2:1 split, you’d end up with 200 shares with a cost basis of $50 per share.

Also, if you participate in a dividend reinvestment program, or DRIP, you will periodically buy fractional

amounts of shares with any dividends paid. Each time you buy additional shares, the cost basis is adjusted. Any cash dividends paid, however, do not reduce your cost basis.

Don’t worry about the details, as your broker will supply Form

1099-B, which shows your cost basis. The cost basis is important to determine, as it is the starting point for figuring out which strategy is best for you.

The Long & Short of ItFor tax strategies, not only is the cost basis important,

but also the amount of time you hold an asset, which is called the holding period. If you hold an asset for one full year or less, it’s considered short term. If you hold for one year plus a day, or longer, it’s a long-term holding period.

Longer-term investments are preferred over shorter term, so taxpayers are rewarded with lower taxes for holding over one year. Of course, long-term investments come with more risk, but we’ll show you how to nearly eliminate the risk but capture the long-term benefits.

For stock market investors, your holding period begins the day after the trade date when you purchased the security and ends on the trade date of the sale. Investors often confuse the trade date with the settlement date. The settlement date, however, occurs three business days after the trade date, which is used for clearing purposes. That’s when the money and shares of stock actually get exchanged.

How do you count the number of days for your holding period? Whatever day of the month you purchase the shares becomes a 30-day marker for each subsequent month regardless of the number of actual days that passed. If you buy shares on February 10, your holding period is one month on March 10 even though fewer than 30 days passed. Your holding period is exactly one year on February 10 of the following year.

In 2002, about 2.2 million taxpayers overpaid by an average of $438.


Capital Gains: The Business of Taxing Profits

Throughout the year, people buy and sell stuff. It may be real estate, cars, antiques, or shares of stock. Whatever it is, if you sell anything for more than the price paid, it’s called a capital gain, and it’s probably going to be taxed. If you sell for less than the price paid, you’ll have a capital loss, which can be used to offset capital gains.

Capital gains represent the largest source of wealth for most people — usually from real estate, stocks, or bonds. They also represent a large portion of taxes, so many tax strategies are devoted to reducing capital gains. To minimize taxes, it helps to understand the mechanics of capital gains and losses.

Let’s say you bought 100 shares of Consolidated Contraptions for $100 per share, which rise to $120 per share. This is called an unrealized capital gain, which just means the gain is on paper only. That is, you can’t spend the $20 gain until you sell the shares and convert them to cash.

If you do sell your shares, it becomes a realized capital gain of $20 per share and you’ll owe taxes on the $2,000 profit. How much tax?

That depends on the holding period. If you held short term (one year or less), you’ll pay taxes at your ordinary income rate. It’s as if the $2,000 was earned from your job. If you’re in the 25% bracket, you’ll owe 25% of $2,000, or $500 tax from that sale.

If you held long term, you’ll get favorable tax treatment, which the government created as an incentive for people to invest long term in capital markets.

For 2013, long-term capital gains are the lowest they’ve been since 1933. If you’re in the 10% or 15% income brackets, you’ll owe zero capital gains taxes! In the previous example, rather than paying $500 tax, you’d pay nothing. Never in U.S. history has the government offered 0% tax on capital gains.

Having no capital gains tax is a gift that’s hard to pass. It was first offered in 2008 and has lingered due to the continued weakening economy, but investors are edgy about how much longer it will last. If you’re holding long-term assets and qualify for no capital gains taxes, it’s worth speaking to your tax adviser to see if it makes sense to sell now.

One word of caution: Several books and Internet sites

suggest taxpayers in the 10% and 15% brackets should take advantage of the 0% capital gains tax and sell all assets with long-term gains. However, understand that the sales are tacked onto your ordinary income. If your ordinary income increases above the 15% bracket, you’ll be taxed at the 15% long-term rate.

Example: Jessica earns $35,000 per year and falls in the 15% bracket. She sells a mutual fund for a $10,000 short-term capital gain believing she’ll owe no taxes. However, the $10,000 capital gain increases her total income to $45,000. Table 1 shows the maximum income amount for the 15% bracket is $36,250 so Jessica’s income is over by $8,750. She owes 15% capital gains tax on $8,750, or $1,312.50. The more long-term assets she sells, the greater the tax.

Paying zero capital gains is a huge benefit, but it’s

only reserved for those in the bottom two brackets of 10% and 15%. All other brackets pay 15% for long-term gains with the exception of the highest income earners in the 39.6% tax bracket, which pay 20% tax for long-term capital gains, but it’s still about half the rate they’d pay if it was short term.

What if you have capital losses? While nobody likes to take losses, at least the government allows you to use them to offset your capital gains, which reduces the

amount of tax you’ll owe. There is, however, a method of applying losses to the gains.

You must group all gains or losses according to their holding period. Put all short-term gains and short-term losses in one group. Put your long-term gains and long-term losses in another. Find the net gain or loss for each group.

For instance, assume you had two short-term sales for the year. You sold Consolidated Contraptions for a $5,000 gain and sold Amalgamated Gizmos for a $2,000 loss. If you combine these, you’re left with a net $3,000 short-term capital gain. Because it’s short-term, you’re taxed at your ordinary income rate, just as if you earned an additional $3,000 at your job.

If you have only long-term gains and losses, net them together as well. If you have a $10,000 long-term gain and a $6,000 long-term loss, you have a net $4,000 long-

The favorable rates for longer-term investors are one of the key reasons that short-term stock traders most often underperform long-term traders.


term gain, which is taxed according to the long-term capital gains rates of 0%, 15%, or 20% depending on your tax bracket.

What happens if you have gains in one group and losses in the other? This is the only time you can combine short term and long term. But first, you must net all short-term together and then all long term together as before. Once that’s done, you can apply the short-term against the long term.

Example: Sara has a $2,000 short-term gain and a $5,000 short-term loss. She also has a $10,000 long-term gain and a $3,000 long-term loss. First, she must combine all short-terms together. On a net basis, she has a $3,000 short-term loss. Next, she does the same for the long terms and has a $7,000 long-term gain. Now she can combine the short-term and long-term figures for a $7,000 - $3,000 = $4,000 long-term gain.

What if you have net losses? Regardless of the holding

period, if you have net losses, you can only deduct $3,000 per year against your taxable income and the remainder gets carried forward indefinitely.

For example, if you have a net long-term $10,000 capital gain and a net short-term $16,000 loss, you have a combined $6,000 short-term loss. You can deduct $3,000 against your ordinary income this year. If you earned $40,000 at your job, you would report $37,000 and carry the remaining $3,000 loss to next year.

The $3,000 limit has been around since 1978 and many are clamoring for change. Sen. Mark Kirk, R-Ill., has introduced legislation to raise the limit to $20,000 per year. But the unanswered question is how it’s going to affect the federal government’s budget, so don’t expect it to change any time soon.

Probably the most important point to understand is that long-term capital gains are better than short-term since they’re taxed at more favorable rates. However, short-term capital losses are better since they reduce short-term gains, which are taxed at unfavorable rates.

Capital gains are also better than ordinary income for a couple of reasons. First, they are taxed at more favorable rates if held long term. Second, you can control the timing of capital gains, which is something you generally cannot do with income. When you

control income, you control taxes.All capital gains and losses are reported on Schedule

D, which are then transferred to Form 1040. If you have no gains or losses, a Schedule D is not filed.Collectibles is another category that falls into a class of its own. These are things like coins (some exceptions apply for coins minted by the U.S. Treasury), fine art, precious

metals, stamps, baseball cards, rare rugs, antiques, rare wines, and others.In prior years, short-term capital gains on collectibles were taxed as ordinary income and taxed at 28% if long term. For 2013, all collectible gains are taxed at 28% regardless of the holding period. If you pay 15% capital gains on other assets, you’re going to pay nearly double that if you’re investing in collectibles.

If you’re investing in collectibles, you can usually find alternative solutions that are more tax friendly. For instance, if you’re investing directly in gold, you’ll pay 28% capital gains but can use a little-known tax secret to pay just 15% with the same risk, which we’ll show in Chapter Four.

For options traders, gains and losses on long calls and long puts are also subject to the holding period, just like stock. However, gains or losses on short options are always taxed at short-term rates, regardless of the holding period.Now that you understand capital gains and holding periods, the following example shows why being off by a single day can make a big difference in the amount of taxes you pay.

Example: Joe buys shares of stock on March 4, 2013. He sells his shares on March 5, 2014 for a $10,000 gain. He believed he sold one year plus one day later, so would pay long-term tax rates. However, his holding period didn’t begin until March 5, 2013 — the day after the trade date — so his holding period is exactly one year and considered a short-term holding period. If Joe is in the 25% bracket, he owes $2,500 in capital gains taxes. If he held for one more day, his taxes would be reduced to 15%, or $1,500. Not knowing how to count the holding period cost him $1,000.

If Joe was in the 15% tax bracket, he’d owe $1,500 in capital gains and zero if he sold one day later – a $1,500 mistake.

Having a basic understanding of taxes is well worth

Short options are always taxed as short-term capital gains.

your time. Investors are notorious for overpaying taxes simply by not understanding the basics. Be sure you understand how to calculate holding periods and ask your tax adviser if you’re ever in doubt.

Step-Up Basis: A Gift for Tax Avoidance

Some of the best tax strategies rely on holding assets until death so that heirs receive what is called a step-up basis. This just means the asset’s cost basis is increased to the current market value at the time of the owner’s death. If an heir sells the security for that price, no tax is due. Zero!

Example: Uncle Joe leaves you 1,000 shares of stock he purchased for $20 per share. On the date of his death, the closing share price was $100. Your step-up basis is $100. If you sell the shares for $100 per share, you pocket $100,000 — and don’t owe a single cent in taxes. If you sell for $110 per share, you owe capital gains tax on $10 per share, or $10,000. And if you sell for less than $100, you get a capital loss.

The step-up basis rule is invaluable for tax planning.

According to Congressional Research Service economist Jane Gravelle, about half of all capital gains in the U.S. are never subject to taxation because of it.

So while you cannot escape death, you can definitely escape some taxes completely. If you have money you’re planning to leave to heirs, it may be better to hang onto investments until your passing so that all those capital gains can be transferred without taxes.

It used to be that people could leave unlimited

amounts of tax-free money to heirs. In fact, Estée Lauder caught the attention of Congress by using similar tactics to avoid $95 million in taxes. But it was all perfectly legal — until

laws changed in 2010.Now you can only leave assets worth $1.3 million tax

free, while surviving spouses may receive an additional $3 million. Beyond those figures, heirs end up with the same cost basis as when the assets were originally purchased. Still, for most people, $1.3 million leaves a lot of room for tax savings.

What types of assets are subject to capital gains taxes? The IRS defines a capital asset as “almost

everything you own and use for personal or investment purposes.” That’s a broad definition, which doesn’t leave many holes. If you bought a baseball card for $5 from your local store and sold it years later on eBay for $10, you technically owe taxes on the $5 capital gain.

Whether people report such small gains is another story. The point is that nearly everything you sell for a profit — including personal property — is taxable, so it’s always best to check with your tax adviser before you go selling things with large capital gains.

While Uncle Sam will take his share on the gains, he isn’t going to share in the losses. If you sell your car for more than you paid, you’ll owe capital gains taxes on the difference. But if you sell your boat for less than you paid, you cannot deduct those losses against the gain on the car.

That’s true even for your personal residence. One thing that surprises most people is that you cannot deduct losses on the sale of your home — but you will owe taxes on any gains.

If you bought a home for $300,000 at the height of the market and sold it for half that amount in 2008, you cannot deduct the loss. The money just evaporated; it’s gone for good. But good tax strategies can keep you from making these mistakes, and we’ll show many throughout this guide.

Wash-Sale RuleTax-savvy investors are always trying to time purchases

and sales to get favorable tax treatment. Years ago, investors would sell shares at a loss, but quickly repurchase them to re-establish the position to generate a tax loss to be used against those shares or other assets.

For example, say you own 100 shares of Novelty Knick Knacks, purchased for $50 per share. The price falls to $40 but you’re confident they’re going to rise. You could sell your shares for $40 and lock in a $10 capital loss. One second later, you could buy another


Long-term capital gains are better than short term. But short-term capital losses are better.

About half of all capital gains in the U.S. are never subject to

taxation because of the step-up basis law.


100 shares of the same stock. With the exception of one brief second, you never really let go of the shares; however, you generated a nice tax loss without altering your risk.

If the share price rises to $50 and you sell, you could collect the $10 capital gain, or $1,000 cash. Because you generated the $10 loss though, you’d owe no taxes from the newly established position.

It was a brilliant strategy — until the IRS caught on.To prevent this easy tax avoidance, in 1921, the IRS

created Section 1091 of the tax code that says you cannot buy (or sell), 30 days prior or 30 days after the sale, a substantially identical security if you want to use the capital losses to offset capital gains.

So there’s a 61-day window where you can get trapped: 30 days prior to the sale, the sale date, and 30 days after the sale. These are calendar days so weekends count as part of the 61-day window.

What is a “substantially identical” security? The IRS is not super clear on this question, but common sense will usually provide the answer. The basic test is to determine if you’re significantly changing the risk or potential outcomes.

If you sell an S&P 500 index mutual fund from Vanguard and buy an S&P 500 fund from Fidelity, those are substantially identical assets. While they are technically two separate mutual funds, have unique ticker symbols, and have different expense ratios, there won’t be much of a difference in their performances or the risks you’re taking. They’re substantially identical.

The IRS has recently deemed derivative contracts on the same underlying asset to be substantially identical. If you sell shares of Microsoft at a loss but buy a Microsoft call option within the 61-day window, the IRS says you cannot deduct the loss on the shares.

Not surprisingly, wash-sale rules only apply to losses. If you sell your shares for a gain and buy back substantially identical shares within the 61-day window, the IRS wants a cut.

Wash-sale violations are one of the most common tax traps, especially for short-term stock traders. It’s not uncommon for new traders to have hundreds of trades throughout the year and generate many gains and losses only to find that none of the losses count. That means one big tax liability at the end of the year — with no losses to offset it.

However, wash sales aren’t necessarily as bad as they sound since you can roll the disallowed loss into the cost basis of your new position. In effect, you do get to use the losses, but must do so in another tax year.

Example #1: David buys 100 shares of ABC stock for $50 per share. He sells for $40, and creates a $10 capital loss. But 31 days later, he buys ABC shares again for $45 per share, which he later sells for $55 and generates a $10 capital gain. David can use the $10 loss to offset the $10 gain. In the eyes of the IRS, because 31 days passed after the first sale, David was not selling his shares just to trigger a loss. He sold the shares and was willing to forgo any potential gains that may have occurred during those 31 days.

Example #2: David buys 100 shares of ABC stock for $50 per share. He sells for $40. But 20 days later (or any number less than 31), he buys ABC shares again for $45 per share. He holds the shares for more than 31 days and sells for $55 per share. David cannot use the $10 loss to offset the $10 gain, because when he sold for $40, he replaced them 20 days later, which is within the 30-day window. His cost basis is now $55 ($45 purchase price + $10 disallowed loss).

Years ago, one way to avoid the wash-sale rule was to

sell shares at a loss in a traditional brokerage account, but buy the replacement shares in a tax-deferred account such as an IRA. The IRS used to view IRAs and other tax-advantaged accounts as a separate entity and therefore the rule didn’t apply. But in 2008, that changed as the IRS Revenue Ruling 2008-5 said that investors cannot claim the tax loss for the sale. What’s worse, the basis on the IRA shares is not increased.

For similar reasons, you cannot sell shares at a loss and have your spouse purchase in his or her account to replace the shares. The IRS says that’s a wash-sale rule violation too.

The reason wash sales can be so devastating is that the investor’s overall portfolio may be unchanged or even down for the year. There may not be enough money to pay the taxes without selling off substantial assets. But the capital gains are still due. And selling those assets may, again, create more unplanned taxes.

As with most tax laws, there are exceptions. If the securities are a gift or inherited, the wash-sale rule doesn’t apply. Also, foreign currency trades (forex), regulated commodity futures, and non-equity options (index options) are excluded from wash sales.


Wash-sale rules can be tricky at first, but to get tax savvy and save money, you have to understand these details. In Chapter Four, we’ll show you some fabulous strategies that avoid wash sales — and still provide favorable tax rates.

Tax Deductions vs. Tax CreditsOf all tax benefits, tax credits are king. But many

investors confuse tax deductions with tax credits, and there’s a big difference.

A tax credit reduces your tax liability dollar for dollar. If you owe $5,000 in taxes and have a $1,000 tax credit, your tax bill is reduced to $4,000. Tax credits are usually offered as economic incentives; examples include education, renewable energy, or hybrid cars.

One of the better-known tax credits is the child tax credit (CTC), and it’s certainly the largest tax benefit to families with children. This was created by the Bush tax cuts, and was set to expire at the end of 2012. However, the fiscal cliff deal signed on January 3, 2013 extended the current CTC for the next five years.

For each child under the age of 17, you get a $1,000 credit. If you have one child and your tax liability is $5,000, it is reduced to $4,000 after the credit. There are some restrictions; for instance, the credit is reduced by 5% if your adjusted gross income is over $110,000 for married couples or $75,000 for single parents.

For continuing education, the American Opportunity/Hope Scholarship Credit and Lifetime Learning Credit are two ways to earn the benefit.

Within the category of tax credits, there are two types: refundable and non-refundable. A refundable tax credit means you receive the full benefit — even if it’s more than your taxable income. If your tax liability is $4,000 but you have a $5,000 tax credit, you’ll receive $1,000 back from the government.

However, if it was a $5,000 non-refundable tax credit, you could only use $4,000 of the tax credit and would not receive the balance from the government. Depending on the credit, you may or may not be able

to roll the extra $1,000 to the following year.Tax deductions work very differently. Often you’ll

hear about new business owners going on spending sprees since business supplies are “tax deductible” and they can “write it off.” They’re under the impression that the entire price will be removed from the tax bill as with a tax credit. That’s far from true. If something is tax deductible, it just reduces your taxable income, assuming you itemize your deductions.

For example, say you earned $40,000 but have a $1,000 tax deduction (or many small deductions totaling $1,000). This just means your taxable income is reduced to $39,000, which falls in the 25% tax bracket. Therefore, your tax bill is reduced by 25% of the $1,000 deduction, or $250. You had to spend $1,000 to get a $250 break on taxes.

If you earned $200,000, you’d fall in the 33% bracket and that same $1,000 tax deduction reduces your taxes by 33%, or $330. Earning more money does mean you’ll pay more taxes, but it also means your deductions become more valuable too. So while it’s true you can write off business expenses, you don’t get dollar-for-dollar breaks like you do with tax credits.

Taxpayers also get exemptions for their children. For 2012, you could exempt $3,800 per qualifying child. This is a deduction, and each qualifying dependent reduces your taxable income by $3,800. Beginning in 2013 though, the government is beginning to phase out this benefit, and a reduction of the exemptions will apply for higher income earners. Tax credits and deductions are important tools for reducing taxes — assuming you don’t mistake deductions for credits.

Armed with these basic terms and concepts, you’re now ready to tackle the three key tax avoidance principles used by the wealthy to pay almost no taxes. By mastering them, you’ll be able to cut your taxes to almost nothing each and every year. Remember, tax laws change, but the principles remain the same.

Chapter Two: See page 15

Don’t ever buy something just to get the tax deduction. You’ll always spend more money than you save.


Look in any bookstore, and you’ll see hundreds of books on tax avoidance strategies. This is why most taxpayers feel like it’s too difficult to learn and end up overpaying at tax time. But there’s a secret to understanding…

Most tax avoidance strategies are based on three key, time-tested principles. If you understand the principles, you’ll know the right questions to ask your tax adviser, and can make more informed plans and decisions about your taxes.

The three principles of tax avoidance are:• Tax deferrals (postponements)• Shifting investments from short term to long term• Shifting income to lower tax brackets

While each principle goes about tax savings differently, they all focus on controlling the timing of income or deductions. It may sound like you need to be a tax pro to understand, but once you know the concepts, you’ll see that avoiding taxes is quite easy.

We’ll give a brief overview of these key principles in this chapter. The following chapters will discuss specific strategies within each category.

Tax DeferralsImagine that you invest $10,000 in a one-year bank

CD (certificate of deposit) that pays 5% interest, and you also invest $10,000 in shares of stock that rise 5% in value. In both cases your investment appreciated by $500.

So conceptually, there is no difference between a capital gain and interest; both represent a return on your money. From a tax perspective, there is a big difference. The bank CD creates a taxable event at the end of the year. You can’t control it and will be required to report it as taxable interest for that year.

However, investing in shares of stock is fully controllable. You determine when to trigger the tax gain or loss by selling. From a tax standpoint, there is big benefit by investing in shares of stock, but there is also a

big difference in risk.Stock prices can fall while bank CDs are guaranteed

to mature to a certain value. However, good tax deferral strategies focus on neutralizing, or at least greatly reducing the risk of falling prices, yet allow you to hold on to your shares long term to avoid taxes. This allows for greater potential returns, controlled tax timing, and lower tax rates.

Tax deferral strategies work because of three key benefits:1. A dollar today is worth more than a dollar tomorrow.2. Capital gains are only taxed when realized.3. There is a step-up basis at death.

The first benefit of deferring taxes is that you get to pay back the government with cheaper dollars. Think of

it as telling Uncle Sam, “I’ll send your money, but not for a long time.”

Tax deferrals are like free loans from the government. If you owe $10,000 today, you may be able to defer that payment and invest the money in a risk-free asset,

such as a Treasury bill or bank CD. If interest rates are 5%, you could deposit $9,524 today, which will grow to $10,000 in one year.

However, if you could defer that tax for 10 years, you’d only need to deposit $6,139 today to make it grow to $10,000. The higher the interest rate and the longer you defer the payments, the cheaper the tax bill becomes today.

The second benefit of tax deferral strategies is that you control the timing of the capital gain or loss; they are only taxable when realized. If your investments have done well this year and you have a lot of taxes due, there’s little sense in tacking on more taxes by triggering capital gains.

By deferring the tax, you may face another year where investments don’t perform too well (remember 2008?), and you may have some losses. You could then trigger some gains which would be more than offset by the losses. The result is that no taxes are due.

The losses don’t go away regardless of your decision,

The longer you defer taxes, the cheaper the tax bill becomes.

Three Key Principles of Tax AvoidanceBroad Categories for Reducing Your Tax Exposure

[ CHAPTER TWO ]

but by deferring taxes, at least you owe less to Uncle Sam.

The third benefit of tax deferral strategies is that you can hold assets indefinitely and never owe one cent in taxes. Your wealth can accumulate, and there are no taxes to pay along the way. And if you hold them until death, your heirs receive a step-up basis, which eliminates 100% of those would-be capital gains taxes.

Of course, many taxpayers wonder about the benefit of holding assets and never selling. Isn’t the entire reason for investing to earn more money so you can become better off today — not upon death? By deferring capital gains, you can still indirectly access the money. Some of the strategies we’ll cover show how to borrow against the assets and deduct the interest. By not paying taxes though, you don’t interfere with the compounding effect, which allows your wealth to grow at a faster rate.

Timing is everything, and you’ll see that tax deferral strategies are a simple, yet powerful tool for avoiding taxes.

Shifting Investments From Short Term to Long Term

The second tax avoidance principle is to shift investments from short-term holding periods to long-term. In some ways, this is similar to the previous principle since you are deferring gains. The difference is that tax deferrals do not attempt to take advantage of the more favorable long-term capital gains rates.

Conceptually, the idea sounds easy: Just hold onto assets for more than one year. However, there is a danger. Prices can plummet.

You may have an unrealized $10,000 gain after 11 months and decide to hold on for another month in order to reduce your taxes. But that gain may quickly

get erased during that time, and it wouldn’t be the first time that’s happened in the stock market. So holding long term just to avoid short-term capital gains is not strategizing; it’s gambling.

The big trick with strategies in this category is risk reduction. We want to attain long-term status safely. We’ll show you how to sharply reduce risk so you can safely hold for long-term status. The amount you save in taxes is one of the keys to building wealth. Remember, short-term taxes are one of the key reasons why short-term investors underperform long-term investors.

Shifting Taxes to Lower Tax Brackets

The third and final principle of tax avoidance strategies is based on shifting income to lower tax brackets.

For 2013, the lowest tax bracket is 10% and the highest is 39.6%; that’s nearly a fourfold increase. This tax-avoidance principle focuses on spreading income to others, usually family members such as children or retired parents who are in lower tax brackets.

Doing so, you get to reduce your taxable income, saving you thousands in taxes. And if it’s money you would pay them anyway, it’s the next best thing to free money. They still get the money, but you pay fewer taxes. The higher your tax bracket, the more you’ll benefit from these strategies.

Almost all tax avoidance strategies fall into one or more of these principles. Once you learn them, you’ll quickly master new strategies that may arise based on current laws. As a reward, you’ll have a lifetime of paying almost no taxes at all.

Chapter Three: See page 17



Most investors overpay taxes and boast about getting big refunds. But this is the most inefficient use of money as you’re giving the government an interest-free loan. At a minimum, put the extra money into a savings account so that you can earn interest.

You do have to be careful though. The U.S. tax system requires you to make periodic tax payments to the government, which is usually done through deductions on your paycheck, or through Form 1040-ES, which is used for businesses to make estimated quarterly payments.

The law requires you to pay at least 100% of your previous year’s tax bill (110% for higher income brackets). If you pay less, there is a penalty, which depends on the amount of the shortfall. There is no reason to pay more than required through the year, however; that’s no way to manage money and reduce taxes, as the additional money can easily be redirected in a way that lowers your taxable income.

As we’ll show later, if you took those tax-free loans you’re giving to the government and put them in a tax-deferred account such as an individual retirement account (IRA), you’d pay fewer taxes.

So let’s take some detailed looks at some of the most overlooked yet powerful strategies to put money in your pocket next tax year — tax deferral strategies.

Hold the Check, PleaseOne of the easiest sources of tax savings is income

deferment. While this is usually a tactic for business owners, it can easily apply to employees as well.

For example, assume you have a side business that you do on weekends. You completed a project in November 2013 for which you will bill your client $5,000. If you receive that money in 2013, you’ll owe taxes on your 2013 return, which is an additional $1,250 if you’re in the 25% bracket. You’ll also owe self-employment tax of 15.3% for an additional $765. Instead, you can bill your client in January 2014, which means it gets reported a year later on your 2014 return.

If you can wait the extra month, you’ll still get full use

of the money through 2014 but save a lot in taxes today. This strategy makes even more financial sense if the $5,000 would move you to a higher tax bracket for 2013.

Of course, be careful that deferring it doesn’t take you into a higher bracket the following year. As long as you’re not at the upper end of a tax bracket, or expecting a banner year, deferring the income will save you money.

Some people think you can defer income by just holding the check, but that can be costly. The IRS

requires you to report income in the year it was received or made available to you, which it calls “constructive payment.”

In the above example, if your client sends the $5,000 check in December, you cannot defer the taxes by just holding onto it and

cashing it in January. The money was made available to you in 2013, whether you choose to take it or not.

Likewise, your broker may receive dividends from some of your stocks or mutual funds in 2013. You cannot defer those payments by simply requesting a check for the proceeds in 2014. Your broker is an authorized agent who can receive income on your behalf. Once the broker receives the dividend checks, you have constructively received the money.

Sending clients a bill in the following year is a different story since you didn’t have access to the money until it was received. This is exactly why most highly-paid CEOs elect to receive their end-of-year bonus checks after January of the following year.

Employees can use a similar tactic by asking their boss to withhold bonus checks or other payments that are not part of their regular pay. If it’s a sizable bonus check, you may even be able to request that the payments be spread out over several years. To do so, you must elect to have it deferred before the beginning of the year where it is scheduled to be paid.

For example, if it’s 2013 and you want to defer a bonus check payable in 2014 to 2015, you’d have to make that election before the end of 2013. Waiting until 2014 to make the request is too late and you’d have to report it on your 2014 return. The IRS has one

You must reportall income in the year it was made available to you.

Tax Deferral StrategiesNever Pay Today What You Can Pay Tomorrow

[ CHAPTER THREE ]


exception to this rule. You have a six-month grace period until June 30 of

the current year to defer any payments to the following year provided they are performance-based incentives. If your boss agrees to pay you a $5,000 bonus in 2014 if you meet certain quotas, you’d have until June 30 to defer that to 2015.

Be cautious if electing to spread payments too far into the future, as there are two big risks.

First, you may unexpectedly find yourself in a higher tax bracket. Second, there’s a chance your company files bankruptcy and all of its assets (including your deferred compensation) may end up going to creditors.

Don’t think this risk only applies to small mom-and-pop companies. Enron was named “America’s most innovative company” by Fortune magazine for six years in a row, yet filed one of the largest bankruptcies in history with nearly $50 billion in assets.

Deferring compensation too far into the future poses too big a risk — even to justify lower taxes. But carefully managed deferrals can be well worth the effort, saving you thousands in taxes each year.

Provide Loans to Uncle SamAnother easy way to defer income is to buy U.S.

savings bonds, which can easily be done online through treasurydirect.com. You can buy two versions: Series I and Series EE.

The bonds work similarly. Both are intended to be longer-term investments and mature in 30 years, although there is only a one-year minimum required holding period. However, if you cash in your bond before five years, you are penalized three months’ worth of interest.

For example, if you sell your bond after 36 months, you’ll only receive the interest for the first 33 months. But after holding at least five years, you will receive the full interest.

You can purchase the bonds in any dollar amount, right down to the penny, subject to a $25 minimum and $10,000 maximum each year per Social Security number. The bonds are sold at face value, so if you pay $25 for your bond, it will mature to a value of $25 in 30 years. You collect interest in the meantime.

The big difference between the two bonds is that Series I bonds are indexed to inflation while Series EE pay a fixed interest rate for the bond’s life, with new rates announced every May 1 and November 1.

Once the rate is announced for the Series EE bond, it pays that fixed interest rate for the life of the bond.

The big benefit with these bonds is that no state or local taxes are due. You will owe federal taxes on the interest but can elect to defer reporting of interest until you file your taxes in the year you cash in the bond or when it matures. (When these bonds mature, they are automatically redeemed and the interest earned is reported to the IRS.)

However, you may not even owe federal taxes if the bond proceeds are used for qualified educational expenses.

In some situations, you may find it more advantageous to report the interest each year. For instance, if the bond is held in a child’s name, chances are the child is paying a lower tax compared to later years.

Of course, with today’s nearly nonexistent interest rates, there’s not much of a benefit in deferring income. For Series EE bonds purchased between May 1 and October 31, 2013, the interest rate is a paltry 0.2%, which means if you invest $10,000 into an EE bond, you’ll get $20 interest per year.

Still, if you’re looking for a way to invest long term and want to avoid annual federal taxes on interest, these bonds offer a great solution.

Tax Efficiency: Getting the Most for the Least

The next tactic for deferring taxes is to choose investments that are tax efficient. A tax-efficient asset simply means you won’t have to pay any taxes (or very few) while holding it.

For example, if you own stocks that pay dividends, you’ll owe taxes on those dividends, which your broker reports to you on Form 1099-B. Even if you don’t sell your shares, dividend payouts will trigger tax consequences each year. In other words, owning shares is not perfectly tax efficient since you cannot fully control all taxable events associated with them. The more tax efficient an asset is, the fewer taxes you’ll owe just by holding it.

To be tax savvy, you must become more tax efficient. While you’ll usually be on the hook for capital gains when you sell any asset, you should reduce your exposure to random payouts that trigger taxable events.

Because you’re not controlling the timing, tax-inefficient assets can throw you into a higher tax bracket and leave you with a surprise tax bill.

Unfortunately, most investors unknowingly do the opposite by using one of the most common investments — and worst tax traps: mutual funds.


The Mutual Fund MousetrapThe mousetrap is a hard invention to beat. It’s

simple, enticing, and efficient. But there’s one financial invention that’s a more efficient mousetrap, at least for taxes. Mutual funds control your capital gains — and kill your tax advantages.

Yet investors use mutual funds more than any other asset as a primary way to invest their savings. While there are certainly benefits with mutual funds such as diversification, ease of investing and switching, and low management fees, there is a big drawback. And it’s one that cannot be overlooked if you’re serious about avoiding taxes. Mutual funds are terribly tax inefficient.

Mutual funds do not pay taxes on the capital gains — shareholders do. In a sense, mutual funds are pass-through entities that just pass the gains and losses onto you and other owners in the fund. The problem catches new investors off guard — and it can be an expensive surprise.

The fund, for example, may hold shares of stock it purchased cheaply 10 years ago. It may sell those shares today for a large gain, say 50%, and you will be responsible for your share of that capital gain, even if you just bought the mutual fund yesterday. But there’s an added danger…

Mutual funds often hold large amounts of cash to redeem shares if investors wish to sell shares. But if markets take a nosedive, the cash on hand may not be enough if investors rush to sell. The fund may have to sell shares to meet the increased redemptions.

This means that mutual funds are likely to be selling when market prices are falling. So you may buy a mutual fund today only to watch its value fall 20% at the end of the year — but find you owe large capital gains taxes anyway.

It’s a double-whammy. It’s one thing to pay capital gains taxes for making money, but paying taxes for losing money is financially irresponsible. It’s certainly not a good strategy for tax avoidance.

There’s a related trap with mutual funds. Current tax law requires that mutual funds distribute at least 98% of ordinary income and capital gains income annually. Therefore, many funds make larger than normal distributions in November or December.

If you buy into a fund just before a large distribution, the fund’s value falls by the amount of the distribution so you’re no better off financially. However, you would trigger an immediate tax consequence on after-tax dollars.

Example: You bought 1,000 shares of Gargantuan Growth Fund in December at $20 per share, for a total of $20,000. The following day, it paid a $2 distribution or $2,000 cash to you. The fund’s value therefore falls by $2 to $18, so now you have $18,000 worth of the fund and $2,000 cash, which is still a total of $20,000.

Financially, you’re no better off. However, you just triggered a tax consequence on the $2,000 cash distribution that wasn’t taxable yesterday. Considering taxes, you’re worse off, and it’s all because you purchased a fund too close to its end-of-year distributions.

You can always look on the mutual fund company’s website, or call customer service if you want to know the exact date. But certainly be careful in December as it is a danger period for this tax trap.

When you invest in a mutual fund, you can elect to

receive distributions in cash, or have them automatically reinvested into additional shares.

Some investors believe they’re not going to get taxed by reinvesting the distributions — not true. Regardless

of your choice, you’ll be subject to income tax.

The only exception is if your mutual fund is held in a tax-deferred account such as an IRA, Roth IRA, or 401(k).

The taxes you owe on these distributions depend on whether

the fund earned ordinary income or short-term or long-term capital gains. It also depends on whether the fund invested in stocks, bonds, tax-free bonds, or other assets.

You don’t need to worry about those details as the fund will send you IRS Form 1099-DIV, which clearly outlines the amount of dividends and distributions. But you should be concerned about the surprise taxes they can throw your way.

As a tax-savvy investor, is there a better way to invest and avoid surprise taxable income?

Reinvesting mutual fund dividends still creates taxable income.

Vanishing Taxes – The Magic of ETFs

In 1993, a brand new world of investing was opened to the United States with exchange-traded funds (ETFs). These funds are similar to mutual funds, as they hold many shares of stock to track indexes, commodities, or market sectors. However, unlike shares of mutual funds, ETFs trade continually like shares of stock on an exchange.

In exactly the same way you’d buy 100 shares of Microsoft, you can buy 100 shares of an ETF. However, unlike mutual funds, ETFs are more tax efficient. Under the Investment Company Act of 1940, ETFs are set up as trusts and have a unique redemption process. In effect, when you sell shares of an ETF, the fund is allowed to swap assets.

For example, if you sell shares of an S&P 500 index ETF, the fund can swap your ETF shares for actual shares of stock that it holds. In essence, your ETF shares are just being swapped with another investor’s purchase.

By using ETFs, you’re just dealing with other investors in the market but using the fund as a channel to connect with other buyers and sellers. The benefit is that exchanging assets is not a taxable event. So ETFs don’t generate internal capital gains taxes like mutual funds do. Instead, investors control the timing and trigger capital gains or losses when they sell.

While ETFs are more tax efficient when it comes to controlling capital gains, any dividends or interest paid by stocks or bonds will get passed to investors just as would be the case with a mutual fund.

Still, ETFs provide investors with a great way to avoid taxes. A Bloomberg study conducted in 2000 showed ETF capital gain distributions were 0.3% of the net asset value (NAV) versus 5.9% for index mutual funds. That’s an enormous difference that represents a huge financial leak if you’re using mutual funds over ETFs.

To become more tax efficient, you must choose your investments wisely. By using ETFs, you can control the timing of short-term and long-term gains. As tax laws change, you can be sure the financial markets will create products to better suit investors.

That’s one of the key benefits you’ll get by following our financial newsletters. Remember, your tax adviser is not going to tell you how to manage your finances. It’s up to you to ask the right questions, so you must keep

up with the newest, most tax-efficient assets. Today, ETFs are hard to beat as a tax-avoidance tool.

While mutual funds are generally not as tax efficient as ETFs, it doesn’t mean you should avoid them completely. Sometimes there are no ETFs to mirror the mutual fund’s objective. If you find a good mutual fund without a similar ETF, place it in a tax-deferred account such as IRAs or 401(k) plans so that you can avoid the taxable distributions each year.

We’ve already covered some basic strategies that will reduce your taxes immediately. Let’s now consider a somewhat more advanced strategy. It’s an easy solution for tax avoidance that can put 30% or more in your pocket.

Harvest Time: Collecting All LossesSavvy investors often hold many assets in their

portfolios, including ETFs and shares of stock. A great tax strategy is to close any losing positions before their one-year anniversary, but hold your winners for more than a year.

Doing so, your gains get long-term tax status, which lowers your tax liability. And if you have any long-term gains, you can use these short-term losses to

reduce your tax liability. If there are no long-term gains, you can use the losses to reduce your taxable income.

This is a tax avoidance tactic called tax harvesting. In other words, just before the one-year anniversary of your holdings, you sell any positions with losses — you “harvested” the losses.

There’s another benefit to this strategy. Price trends — whether up or down — last much longer than investors suspect. Harvesting losses for tax avoidance means you’re more likely to cut your losses short, and let your winners run.

ETFs are great tools for harvesting losses since they can be purchased on specific sectors. This allows you to sell an individual stock but replace it with a sector ETF. Doing so, you don’t miss out on the exposure — but do avoid wash-sale rule violations.

For instance, say you paid $10,000 for shares of Wells Fargo (WFC) and it’s worth $9,000 just prior to the one-year anniversary of your purchase. You can sell those shares to get the tax loss but immediately buy the Financial SPDR Sector (XLF), which will still closely track the performance of all financial stocks.

In fact, in August 2013, Wells Fargo represented


By using ETFs, you’re exchanging assets with other investors, which is not a taxable event.


8.51% of XLF. You still get good exposure to financial stocks, but it’s far from “substantially identical” so you won’t have to worry about violating the wash-sale rule. The tax benefit is enormous.

For all practical purposes, not much has changed in terms of risk, but you do have a $1,000 loss to apply against your income. How much of a difference does this make?

Let’s say XLF rises 10% after you’ve held it for one year. Had you just purchased this ETF rather than Wells Fargo, you’d have a 10% unrealized gain. However, because you harvested losses, you reduced your taxable income. If you’re in the 30% bracket, you reduced income by $3,000, which is 30% of your $10,000 investment. Your total return is therefore 10% + 3% = 13%.

It may not sound like much of a difference, but it’s 30% higher. If you’re in a relatively high tax bracket and have a portfolio of stocks, the savings can easily be tens of thousands of dollars. Tax avoidance strategies are enhanced when you find many small ways to make one big difference on April 15.

1031 Exchanges: Buying Real Estate With Deferred Taxes

Just as you can defer taxes on shares of stock, you can also do similar deferrals with real estate. Section 1031 of the tax code outlines another little-known strategy that investors can use for real estate transactions.

It’s called a 1031 exchange, named after that section of the tax code.

Conceptually, it’s a simple strategy where you swap one or more investment properties for one or more properties of equal or greater value within a certain time, usually six months.

By investment properties, it means you cannot use 1031 exchanges for your personal residence. The benefit is that you end up with exactly the same result as if you sold one property and bought another.

However, in the eyes of the IRS, you are swapping the properties, and the benefit is that exchanges of property or assets are not taxable. (It’s this exchange principle that allows investors to escape capital gains on ETFs since they’re exchanging shares with other investors and not buying and selling shares as they do with mutual funds.)

The idea behind the 1031 exchange is that when you swap properties, you’re not receiving cash from the sale, so no economic gain has been realized. There is no sale, so there is no tax.

Example: Sharon purchased land in 2000 for $100,000. In 2005, it was valued at $150,000. If she sells it to buy a rental duplex, she’ll pay a capital gain on $50,000. If she’s in the 28% tax bracket, her tax bill is $14,000. However, she can do a 1031 exchange for a property of equal or greater value and the $50,000 unrealized gain will not be taxed. This means she can afford a better investment property since she doesn’t lose $14,000 by paying capital gains taxes.

Of course, a 1031 exchange doesn’t mean taxes just

disappear. Instead, it essentially creates an IOU to the IRS. After all, it’s a tax-deferral strategy, not a tax-removal strategy.

When you sell the exchanged property, the taxes from the original property are paid, which includes all capital gains from the original purchase date.

However, you don’t have to stop after one property. You could continue doing 1031 exchanges and defer taxes for decades. In fact, if you continue until death, your heirs receive a step-up basis, which is the fair market value at time of death. The property could be sold and no capital gains taxes would be due — even on the accumulated gains.

Several conditions apply to 1031 exchanges. As stated before, the relinquished property and replacement property must be used for business or investment, and not personal residence.

However, you can use a 1031 exchange for residences if you turn your home into a rental property before you sell it. To do so, you must rent your home for an appreciable amount of time, which is not specifically defined by the IRS. Most experts agree that a one-year rental period should be sufficient to establish it as an investment property.

Also, if you’re buying property for immediate resale, such as “flipping” homes, it doesn’t qualify for a 1031 exchange.

A second condition is that the property you’re relinquishing and replacing must be similar, or what is called “like-kind.” That just means they must serve similar roles. Just about all real estate is considered like-kind and can be exchanged for other real estate.

For example, you can swap vacant land for a rental home, or an office building for a shopping center. You do not have to exchange one-for-one either. Depending on valuations, you may exchange one property for three, for example.


Location matters too. If you relinquish a property in the United States, you must replace it with another U.S. property to be considered like-kind. You generally must designate a replacement property within 45 days of the 1031 exchange and close within 180 days.

Also, you don’t have to swap the two properties at the same time. You can sell your existing property and then buy the replacement property. There are also reverse exchanges where you buy the replacement property first and then sell the existing property.

The 1031 exchange is an extremely versatile tax-deferral tool. Regardless of how it’s used, the key benefit is that it allows investors to accumulate wealth faster since they’re using pre-tax dollars to continually buy and sell. It’s not just a tax deferral strategy; it’s a wealth builder too.

These are just the highlights of a 1031 exchange, and you’ll always want to consult a tax adviser to carry out the exchange as there are intricate details that must be followed. Awareness of the strategy, though, can save tens of thousands of dollars if the opportunity arises where you need to swap one property for another.

Installment Sales: Will That Be Cash or Credit?

Just because you can’t use a 1031 exchange for residential property doesn’t mean you can’t defer income; however, you must do it through an installment sale. An installment sale occurs any time you receive at least one payment after the tax year of the sale.

A key condition is that installment sales only count if you sell the property for a gain. You can use installment sales for real estate, business sales, and investment property. You cannot use it for selling shares of stock or other securities traded on an exchange.

With installment sales, you accept a portion as a down payment today, and then receive a note from the buyer for the remainder, which usually includes interest. Each payment you receive contains a return of your purchase price, and return of the gain on the sale.

For example, assume you paid $100,000 for your home years ago but sold it for $250,000 in 2013. If you sold for cash today, you’d incur $150,000 capital gains tax.

However, by using an installment sale, you can reduce your capital gains. Let’s say the buyer gives you $50,000 as a down payment and a note for the remaining $200,000 to be paid over five years, so that you’ll receive $40,000 each year. If any interest is charged, that would

be tacked onto the payment.For each $40,000 payment received, only $30,000 is

counted as income. The remaining $10,000 is counted as a return of your purchase price so is not taxed. In other words, after five years you’ll receive $30,000 x 5 years = $150,000, which is the amount of the capital gain. You’ll also receive $20,000 x 5 years = $100,000, which is the return of your purchase price.

Your taxable income gets $30,000 added to it each year plus any interest that may be paid. Interest is taxed as ordinary income while the capital gain is taxed at the lower rate. It’s a simple way to defer income and possibly get a higher selling price since you’re offering to finance the deal.

Save for Retirement and Avoid Taxes

One of the most widely used ways to defer taxes is by contributing to a retirement account, such as an individual retirement account (IRA), Roth IRA, 401(k), or 403(b) for nonprofit organizations.

Anyone — even children — can contribute to a retirement account as long as they have earned income, which includes:• Wages, salaries, tips, and other taxable pay• Union strike benefits• Long-term disability benefits received prior to

minimum retirement age• Net earnings from self-employment

Income that does not count as earned income includes:• Pay for work while in prison• Interest and dividends• Retirement income• Social security• Unemployment benefits• Alimony• Child support• For kids, gifts from grandparents

In Chapter Five, we’ll show you how you can create income for your children, which further lowers your taxes too.

Tax-advantaged accounts work in one of two ways. With some plans such as a traditional IRAs, Simple IRAs, SEP IRAs, 401(k), and 403(b) plans, you get to deduct your contributions from your income today. You’re contributing with pre-tax dollars.

Because those dollars haven’t been taxed, you must pay taxes when you withdraw money at retirement.


By contributing to these plans, you get lower income taxes today and don’t pay the tax until years, possibly decades later. Those are great benefits by themselves, but there’s an added advantage…

Over time, your portfolio will likely gain value as asset values appreciate. Some stocks and bonds will also pay dividends. Your money market will pay interest. Rather than paying capital gains taxes when you sell, or paying annual taxes on dividends and interest, you’ll defer those payments as well. So all capital gains, dividends, and interest grow tax deferred too. Because of the power of compounding, the results can be staggering.

The return on a $10,000 investment with no taxes will more than double in value over 30 years ($174,500) relative to the same investment with 30% taxes ($76,120) as shown in Chart 1 below:

The above chart shows the growth for a single investment. Imagine if you could contribute more money every year. Well, you can!

Each year, tax laws define the maximum amount you can contribute to tax-deferred plans, no matter how many you may qualify for. For 2013, the maximum limit is $17,500. There are, however, additional dollars you’re allowed to contribute if you’re at least 50 years old by December 31. These are called catch-up contributions, and were designed to give an economic incentive for those approaching retirement who’ve fallen behind in making past contributions or just trying to bolster their nest egg.

Beginning in 2001, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) allowed catch-up

contributions to IRAs, 401(k), and other tax-deferred plans for those 50 years old and over. Under the original EGTRRA rules, the catch-up contributions were set to end in 2011. However, the Pension Protection Act of 2006 made catch-up contributions and other pension-related provisions permanent.

The first catch-up provision began in 2002 at $1,000 and was increased by $1,000 each year through 2006 to a maximum of $5,000. The government adjusts this limit for inflation, but only in $500 increments. For 2013, the maximum contribution is $5,500 for those under age 50, and $6,500 ($5,500 standard + $1,000 catch-up) for those over age 50.

Tax deferred contributions — especially catch-up clauses — are government incentives to encourage retirement savings, and will lower your current taxes as a result if you take advantage of the gift. Few people do. A recent study of those with Fidelity-administered 401(k) plans showed the percentage of employees 50-plus making catch-up contributions is only 12.9%.

It’s little wonder why the rich continue to get richer and everyone else is taxed to death. Tax deferments are wonderful incentives to prepare for retirement and defer today’s taxes as well.

Most 401(k) plans offer catch-up clauses as well, but it’s entirely up to the plan. According to the Plan Sponsor Council of America (www.psca.org), 98% of all 401(k) plans allow catch-up contributions. There’s very little reason to not be taking advantage of this tax deferral.

Think about the savings if you’re socking all kinds of tax-free money away. If you make $50,000 per year, you’re in the 25% tax bracket. If you contribute $5,500 to a traditional IRA, you’ll deduct that amount from your gross income and report only $44,500, which saves $1,375 in taxes today (25% of $5,500).

When you withdraw the money at retirement, you’ll pay ordinary income tax on the distributions — regardless of the capital gains. For most people, their retirement tax bracket will be much lower than during their working years. So while your capital gains may dramatically increase, you may only be taxed at 10% or 15% upon withdrawal.

However, understand the IRS imposes a 10% penalty for early withdrawals before age 59½. If you withdraw $10,000 early, you’ll pay ordinary income tax on the full amount — plus a $1,000 penalty. While IRAs are fabulous tax deferment tools, don’t get over-anxious and contribute so much that there’s a good chance you’ll need to withdraw it early.

Chart 1: $10,000 investment over 30 years with 30% tax vs. no tax:

$200,000 -

$180,000 -

$160,000 -

$140,000 -

$120,000 -

$100,000 -

$80,000 -

$60,000 -

$40,000 -

$20,000 -

0 -0 5 10 15 20 25 30

No taxes

30% taxes


Despite the benefits of tax-deferred savings, the government eventually wants its share. Beginning at age 70½ there are minimum withdrawals you must make.

To summarize, the first type of tax deferment plan is where you contribute pre-tax dollars; however, you pay taxes on that money when you withdraw it at retirement. For most people, this will be with IRAs and 401(k) plans. The benefit is that you reduce current income taxes, and the taxes you pay upon withdrawal are deferred until well into the future.

Sounds like a great idea, but wouldn’t it be nice if you could withdraw the money — and pay no tax? You can do that too with a Roth IRA.

The Roth IRAThe Roth IRA was established under the Taxpayer

Relief Act of 1997, sponsored by Senator William Roth of Delaware.

This second type of retirement plan is where investors can contribute today with after-tax dollars. That is, you pay taxes on the money today and do not get to reduce your current income. However, when you withdraw money at retirement, you’re not taxed at all. While the Roth IRA is the primary tool for most people to use after-tax dollars, some 401(k) plans allow employees to contribute after-tax dollars too.

That’s why the Roth IRA is called a tax-free retirement account, which has a nice ring to it. However, that only means it’s tax-free when you withdraw money at retirement. It’s not truly tax-free since you pay taxes when you contribute money to the Roth IRA.

Still, while paying no taxes upon withdrawal sounds like a wonderful benefit, you must consider other factors.

First, if you feel you will be in a much lower tax bracket at retirement, you may be better off reducing today’s income by using a traditional IRA, 401(k), or other plan where you contribute pre-tax dollars.

However, with the out-of-control federal deficit, increases to Social Security, Medicare, and other expenses for the mass of baby boomers continuing to retire, it’s not a far stretch to think taxes will rise.

If you believe your retirement tax bracket will be higher, you may want to consider paying the taxes today and using a Roth IRA.

With a Roth IRA (and some 401(k) plans), you can withdraw your contributions at any time without penalty

since the money has already been taxed. You cannot, however, withdraw your earnings before five years without being subject to taxes and penalties.

Example: Sam contributes $2,000 each year for four years to a Roth IRA, for a total of $8,000. During that time, his account value has increased to $10,000. Sam can withdraw up to $8,000 without penalty. But if he withdraws more, he’ll pay a 10% penalty for tapping into the $2,000 gains. If five years had passed instead, he could withdraw the entire $10,000 without penalty. Also, no matter how many Roth IRAs Sam has, they are treated as one for withdrawal purposes. If he has one account worth $8,000 and another worth $2,000, he’s still limited to the $8,000 sum. He may, for example, withdraw $7,000 from one account and $1,000 from the other.

Because nobody knows for sure what’s going to

happen to future tax rates, another strategy to consider is hedging the uncertainty and contribute to both types of accounts, such as a traditional IRA and a Roth IRA.

Remember, you can contributing to multiple types of retirement accounts as long as you don’t exceed the maximum limit, which is $5,500 for traditional and Roth IRAs combined. (However, if you also use a Simple IRA or Simple 401(k) plan, you can contribute

an additional $12,000 for a total of $17,500 each year.)

By contributing to traditional and Roth IRAs, you can withdraw from the account that offers the best advantage at that time. If taxes are high, withdraw from the Roth; if they move

lower during retirement, withdraw from the taxable account and pay the taxes.

Be careful about your withdrawal choices though. All things being equal, you’re better off withdrawing from the taxable account first, such as a traditional IRA.

The longer you leave your money in a tax-free account, such as a Roth IRA, the more you’ll benefit from the power of tax-free compounding as shown in Chart 1. Many retirees make the mistake of withdrawing from their Roth accounts first since they pay no taxes. While it seems to make good financial sense, there is usually a bigger cost of lost tax-free earnings.

Unlike traditional IRAs, the Roth IRA carries no

You’ll lose tax-free compounded returns by withdrawing from your Roth first.


required distributions at age 70½. The money has already been taxed so the government doesn’t impose mandatory withdrawals.

Regardless of your views on future tax rates, there’s no disputing that you’ll be better off by contributing to your own retirement, reducing today’s income taxes, and deferring those taxes well into the future.

Tax deferral strategies are one of the simplest ways to reduce taxes. As tax laws evolve, strategies will

change, timings will change, and the amounts you save will change. But one thing that never changes is the principle of tax deferrals. Understand the principle, and you’ll see new ways to avoid taxes as new laws are created.

If you’re not using this powerful tax-avoidance strategy, you’re overpaying your taxes.

Chapter Four: See page 26


The last chapter showed that tax deferrals are powerful strategies by themselves. But when you combine them with other tactics, you’ll see that avoiding taxes is quite easy. And that’s what we’re going to do in this chapter. It’s now time to look at our second principle of tax avoidance, which is to shift your investments from short-term holding periods to long term.

The main reason for these strategies is straightforward; it’s to take advantage of the more favorable long-term capital gains rates. Remember, short-term holdings are taxed as ordinary income. For 2013, you could pay as much as 39.6% in capital gains taxes. For long-term holdings though, you pay no taxes if you’re in the 10% or 15% brackets, and 15% for all other brackets except the 39.6% bracket, which is taxed at 20%. It’s worth figuring out ways to safely hold long term.

Think about the potential for a moment. Capital gains are the largest source of wealth for most people. By shifting your holding period to long term, all tax brackets fall by an average of 50% with the exception of the bottom two brackets, which fall 100%. It’s an offer that’s hard to refuse.

Using tax strategies to create long-term holds is a standard for tax-savvy investors. Even legendary investor Warren Buffett said his favorite holding period is forever, and now you know why. It’s not what you make; it’s what you keep. And with today’s tax structures, you can keep a lot more by holding investments long term.

While capital gains taxes apply to nearly all assets that are sold for a gain, most taxpayers create capital gains through sales of stocks, bonds, and real estate, so those will be our focus.

Let’s say you bought 100 shares of International Widgets for $100 per share and sold for $120 per share. This is a $20 per share capital gain, or $2,000 total. The amount of tax you owe depends on whether you held the shares short term (one year or less) or long term (one year plus a day or more).

If you sell your shares within one full year, you have a short-term capital gain, and the difference between your purchase and selling price, $2,000 in this example, is taxed as ordinary income according to the rates in Table 1. If you earned $50,000 during the year at your job, this $2,000 capital gain gets tacked on as income since it’s a short-term gain. Effectively, you earned $52,000, which falls in the 25% tax bracket, and you’d owe 25% of $2,000, or $500 extra in taxes because of that sale.

However, if you held the shares for more than one year, you get a big break since it’s a long-term holding period. If you’re in the 10% or 15% income brackets, you’d reduce your taxes from $500 to zero.

With the exception of the highest 39.6% tax bracket, all other brackets will pay 15% capital gains tax, which is 15% of $2,000 = $300 — a 40% savings compared to the $500 you’d owe by selling short term.

And finally, if you fall into the 39.6% bracket, you’d owe 20% capital gains. Your taxes would normally be $792, but only $400 by selling long term. You can see

that regardless of your bracket, taxes are significantly reduced — and your income increased — by creating long-term holding periods.

Don’t get hung up in the specific numbers as those will change from year to year. What has remained constant in tax laws is that investors are

provided with favorable rates for longer-term holdings as an economic incentive for investment. By turning short-term holds to long-term status, it’s money in your pocket. There is, however, a trade-off…

In the financial markets, time is risk. You don’t want to hold long term just for the sake of reduced taxes. It’s not much of a financial strategy to save 40% in taxes but lose far more in value. That’s penny wise and dollar foolish. But that’s the mistake most investors make. As an extreme case, some employees with incentive stock options have held on for long-term status but have seen their share value fall substantially, thus creating an alternative minimum tax greater than the shares’ value.

To hold investments blindly just for long-term tax

Select assets that don’t trigger taxable events throughout the year. You want to control the timing of the taxes and create long-term gains when possible.

Shifting Investments From Short Term to Long TermHow to Control When You Pay Uncle Sam for Lower Taxes

[ CHAPTER FOUR ]


treatment is not a tax strategy — it’s simply accepting more risk. To count as a good tax strategy, you need to find ways to achieve long-term status without significantly increasing risk. So let’s find out how to create long-term holding periods for big tax savings without increasing the chances for big losses.

Choose Your Investments with Taxes in Mind

As the most basic strategy, consider buying assets that don’t pay interest but, instead, are expected to appreciate over time. Interest and capital appreciation are two forms of a return on your money; however, interest (or dividends) is taxable upon receipt, which is usually quarterly or annually so it will always be taxed at short-term rates. Capital appreciation is never taxable — until you turn it into a capital gain by selling.

Select assets that don’t trigger taxable events throughout the year. You want to control the timing of the taxes and create long-term gains when possible.

To make it a good tax strategy, you must neutralize, or at least reduce, the risk while holding the assets. But that’s easier said than done because of the dreaded tax straddle rules.

Dodging the Sinister Tax Straddle Rules

Most investors think it’s easy to create long-term holdings by using options to hedge, or protect stock and ETF positions. Using options, however, can trigger little-known tax consequences when trying to create long-term holdings while reducing risk.

For example, assume you bought 100 shares of Worldwide Trinkets for $30 per share. After 10 months, you have a nice gain with the shares trading at $50, but don’t want to sell because you’d trigger a short-term capital gain.

To protect your shares’ value, you decide to purchase a two-month $50 put option. This is a common strategy called a protective put since it protects your shares’ value. How?

Buying the two-month $50 put gives you the right, not the obligation, to sell your shares for $50 per share at any time during the next two months. Your downside risk is now protected as you’re guaranteed to receive at least $50 per share.

If the stock price climbs above $50, the put option expires worthless and you can sell your shares at the current, higher market price. And if the stock price

falls below $50, you would exercise the put and collect exactly $50. By purchasing a two-month put option, you may receive more than $50 per share, but you could never receive less, so the downside risk is protected. All you need to do now is hold the shares risk free for another couple of months to establish a long-term gain. Sounds great, but there’s a small problem…

It won’t work. The reason is the IRS has a complex set of rules called tax straddle rules (Section 1092 of the tax code). The rules have nothing to do with the options strategy called a straddle; instead, they apply to any strategy where the investor is trying to simultaneously hold a long (shares you own) and short stock position to substantially reduce risk.

Buying a protective put falls into this category of tax law since you own shares while the put option acts as a short stock position. The same is true of protective positions that could have been accomplished in other ways, such as with in-the-money call options or stock collars. As long as they substantially reduce the risk of the shares, they’ll violate tax straddle rules.

The key is to determine if the protective position “substantially reduces” the risk, which is obviously ambiguous, and that’s one of the things that makes these rules so tricky. This is where your tax adviser can help. However, to be tax savvy, you should at least understand the basics.

Tax straddle rules have two main components:First, if you buy a put option to protect shares of stock

that have been held for less than one year, you forfeit the stock’s holding period. In other words, the entire holding period that you’ve accumulated so far is erased. What’s worse, the clock doesn’t begin ticking again — starting from zero — until the put option expires or you sell it.

Second, if you’ve held your shares for more than one year to establish a long-term gain, you can buy a put option (or other protective position) and any gains or losses on the put are treated as long term. The reason is that it was used to hedge a position that already received long-term status.

Example: Jack buys 100 shares of Worldwide Trinkets and held for more than one year. Later, he buys a short-term put option to protect the downside risk, which expired worthless. The loss on the put is considered a long-term capital loss even though it was held for less than one year.


So while you can greatly reduce the risk of holding shares by purchasing a put option, the tax straddle rules don’t allow you to extend the holding-period clock from short term to long term.

While tax straddle rules have been around since 1981, they still catch even the savviest of investors off guard. Don’t be one of them.

A famous case involved billionaire American entrepreneur Philip Anschutz, who used a variation of buying puts to defer taxes. A U.S. tax court ruled Anschutz owed $94 million in back taxes for transactions entered in 2000 and 2001. He appealed and lost. While you often hear how the wealthy get favorable treatment, they can’t get past the tax straddle rules. But there is one way to do it that few people know…

Tax Wedding Bells – The Married Put

For investors who wish to hold shares long term but greatly reduce their risk, there’s a little-known tax strategy called a married put. To create this position, you must buy the shares and the put simultaneously (executed as one trade), or as two separate orders on the same day. In addition, you must have the broker note the confirmation that the put was purchased as a hedge against the shares of stock.

Further, the married put conditions can only be met by delivering the actual shares purchased with the put, or by letting the put expire worthless.

For example, assume you buy 100 shares of International Doodads for $25 per share and a one-year $25 put on August 5, and have the broker note the confirmation to show the shares and put were purchased together as a hedge. It becomes a married put position.

However, let’s say you purchased another 100 shares of International Doodads one month later on September 5. If you exercise the put in a year, you must deliver the shares purchased on August 5. Even if it’s more advantageous for you to deliver the shares purchased on September 5, you cannot do that. Part of the deal is that the original shares and put stay together; after all, they’re married.

The married put rules stem from Section 1233(c), which creates the exception for the forfeiture of the stock’s holding period as would normally be the case

with tax straddle rules.If you’re buying shares that you want to hold long

term but are afraid of potential losses, consider the married put strategy. You can confidently hold it through the life of the option and always know your maximum loss. However, you have unlimited potential gains that you know will be taxed at favorable long-term rates.

Since 1921, the tax codes were written to encourage longer-term investing. Remember, tax codes were primarily designed to encourage economic activity. By leaving your money invested in the capital markets longer, you are granted a benefit of paying fewer taxes.

So while many investors buy put options to defer capital

gains, the strategy doesn’t work unless it’s a married put. To increase your returns and become more tax efficient, consider using married puts, especially when purchasing volatile stocks.

Naturally, there is a problem with holding long term, even with reduced risk. Many times you may find yourself needing money before your shares have reached long-term status. How can you get cash, but not trigger a short-term sale?

Borrowing to Avoid Short-Term Taxes

Rather than selling short-term assets and creating taxable events at unfavorable rates, there’s a better method.

Tax-savvy investors will borrow the money and use the shares as collateral. While you can make arrangements with any financial institution, the easiest way is to use a margin account through your broker.

If you currently have a margin account, you automatically qualify for loans and can request a check with a simple phone call or online check request. If you don’t have a margin account, just tell your broker you’d like to open a margin account. It’s a short form and takes just a minute to fill out. Margin accounts, however, can only be used with traditional types of accounts and not tax-advantaged accounts such as IRAs.

By signing the margin agreement, you’re agreeing to pledge the assets in the account as collateral for the loan. Because the broker holds the shares (collateral), you’ll get much better rates than you otherwise would

The married put strategy allows you to safely hold long term. You protect your investment and pay lower capital gains taxes.


through a non-collateralized loan, such as with credit cards or loans based on your salary and credit history. Even better, if the money is used for certain investment purposes, it may be tax deductible using Schedule A and Form 4952.

The exact amount you’re allowed to borrow at any time depends on market prices and other factors. Generally, you can borrow up to 50% of your account value. If you have $50,000 worth of stocks, bonds, mutual funds, or other assets, you’ll be able to borrow about $25,000.

Borrowing against your account’s assets is not without risk though. If the value of the assets in the account falls substantially, you may have to deposit more money to bring the equity up to minimum levels.

So if you borrow against your shares, be sure you have a backup plan to repay the loan. The main point to understand is that you do have alternatives for getting cash other than triggering a lot of short-term gains and losses.

This is where a tax professional can really come to the rescue as everyone’s situation is different. The main point to understand is the strategy of shifting your assets to long-term gains doesn’t necessarily mean you cannot tap into the equity. Consider borrowing against the shares. You can get the money today and let your holding-period clock continue to tick toward the more favorable long-term status.

Safely Deferring Capital Gains After One Year

With the exception of the married put strategy, buying puts causes you to forfeit the stock’s holding period.

However, if you’ve held shares for over a year (one year plus a day), without the protection of the put option (or by using the married put strategy), you’ve established a long-term holding period on your shares. Once that condition is met, your shares can never be reduced to a short-term holding period — even by purchasing put options or other strategies for protecting the downside risk.

So there’s another potentially wonderful strategy for tax-savvy investors here. For those who have held shares for more than one year, purchasing put options is a great way to continue holding without the fear of

losses. The put options allow you to continue to safely defer taxes, and any gains or losses on the put are treated as long term. By using put options, you can wait for advantageous times to trigger capital gains.

Saving 12 Percent Is Easy as 1-2-5-6How would you like to invest short-term but get

taxed at favorable long-term capital gains rates? Well, you can — at least to a large degree.

To be among the most tax savvy, you must be aware of a little-known category of investments that can save you 12% at tax time. The IRS calls these 1256 contracts, which are named after that section of the tax code — and they carry amazing benefits for short-term investors.

The term “contracts” refers to derivative contracts such as options and futures. But not just any contracts qualify; there are a number of conditions they must meet.

First, a 1256 contract must be a non-equity exchange-traded option or futures contract. That

is, it cannot control equities, or shares of stock, such as Microsoft or Google.

Instead, the contracts must be non-equity and cover cash-settled broad-based indexes, commodities, or currencies. Other cash-settled indexes qualify too such as the Volatility Index, which is an essential tool for options traders.

Second, to qualify as a 1256 contract, they must be exchange-traded contracts, which means they trade on regulated exchanges such as the CBOE (Chicago Board Options Exchange), and not privately negotiated through securities dealers.

Why do tax-savvy investors flock to these hidden gems? If you buy or sell a qualified 1256 contract, you’ll be taxed at 60% long-term rates and 40% short term regardless of how long you hold the position.

These contracts were originally designed to hedge short-term risk, but to encourage their use, the government allowed this favorable 60%-40% tax split. And it’s a gift for short-term investors.

For comparison, recall that normal taxation rules require assets to be taxed as ordinary income if held for one year or less. The only way to get favorable long-term rates is to hold for more than one year.

But with 1256 contracts, you can hold for minutes, days, or months and you’ll get 60% of any gains taxed at long-term rates. Because of the unusual 60%-40% split,

1256 contracts are taxed as 60% long term and 40% short term regardless of how long you hold the position.


investors who hold short term will save a bundle at tax time. Also, 1256 contracts are excluded from the wash-sale rules; you can buy and sell as often as you’d like without having to worry about wash-sale violations as outlined in Chapter One.

Identifying a 1256 contract can be tricky, so it’s always a good idea to check with your tax adviser if you’re unsure. For example, options and futures on DJX (Dow Jones Industrial Average), NDX (Nasdaq 100), and RUT (Russell 2000), qualify as 1256 contracts.

However, options on ETFs covering the same indexes above do not qualify. If you buy or sell options on SPY (S&P 500), DIA (Dow Jones Industrial Average), QQQ (Nasdaq 100), and IWM (Russell 2000), they don’t qualify as 1256 contracts since they’re not cash settled. Instead, they settle in ETF shares.

Not all ETFs, however, are structured the same. Some are called grantor trusts, which qualify for 1256 tax treatment. The SPDR Gold Trust (GLD) is a popular ETF for investors who want exposure to gold but also want the favorable short-term tax treatment.

To see the benefits, let’s say you’re in the 28% tax bracket and wanted to use short-term options on the S&P 500 index. If you buy or sell options on SPX, you’ll get the 60%-40% favorable tax treatment. If you use SPY, however, you wouldn’t since it’s an ETF. The difference is costly.

If you buy an option on SPY (a non-1256 contract) and have a $1,000 gain you’ll pay ordinary income rates of 28%, or $280.

However, that same option on SPX (a 1256 contract) will be taxed at a blended rate of only 20.2% for the same $1,000 gain. To see why, the first 60% of your gains, or $600, gets taxed at the long-term capital gains rate of 15%, or $90.

You’ll be taxed on the remaining $400 at the short-term rate equal to your 28% tax bracket, or $112. Your total tax is $90 + $112 = $202, which is 20.2% of your $1,000 gain.

The savings are even more pronounced for those in the higher tax brackets. If you were in the 35% bracket, you’d be taxed at a blended rate of 23% for using 1256 contracts and 35% otherwise — a savings of 12%.

Investors in the lower tax brackets of 10% and 15% benefit too but not to the same degree since they pay 0% long-term capital gains rates. Investors in the 10% or 15% brackets would be taxed at 6% for using 1256 contracts and 15% otherwise, a savings of 9%.

While 1256 contracts create favorable capital gains rates for short-term investments, they create

unfavorable tax rates if holding long term. That’s because you’re getting 40% of your gains taxed as short term even though you’ve held the position for more than one year.

In the previous example your $1,000 gain was taxed at a rate of 20.2%. For long term though, you’d pay the 15% flat rate. To become tax savvy and avoid unnecessary taxes, consider 1256 contracts for your short-term investments. Are there any drawbacks?

There is one oddity with 1256 contracts. To prevent investors from deferring income or converting short-term capital gains to long term, the IRS requires that all 1256 contracts are treated as “closed” on December 31, or the last business day of the year.

This process is called marking-to-market, which simply means you’re valuing, or marking, the asset to the market price.

Therefore, if you have an unrealized gain at year end, you’re going to pay tax on it as if you had closed the position. And if you have a loss, you can deduct the loss even though you’re still holding the position.

While it may seem like a bad deal to pay taxes on something you didn’t sell and a great deal to write off a loss you never realized, your cost basis gets adjusted too so mathematically it washes out. Any gains get added to the cost basis while any losses are subtracted.

For example, assume on May 1, 2013, you purchase a qualified 1256 options contract for $10,000. On December 31 (or last business day of the year) the contract’s closing value is $12,000. Even though you didn’t sell the contract, you must recognize a $2,000 capital gain on your 2013 taxes with 60% treated as long term and 40% as short term. Your cost basis increases to $12,000.

The following year, assume you close the contract for $11,000. You’d recognize a $1,000 capital loss, again with 60% being long term and 40% short term. The reason it’s a loss is that your effective cost basis is $12,000 from the previous tax year.

So while it wasn’t a good deal to pay tax on $2,000 you didn’t receive, it came back to you by collecting a $1,000 gain but getting to write off a $1,000 loss.

The marking-to-market feature is also handy for generating guaranteed gains or losses at year end without having to actually close position. Depending on your tax situations and strategies, 1256 contracts may create the necessary gains and losses but still allow you to maintain exposure to the indexes.

Consider using 1256 contracts for short-term trades that you know will be closed out before year end. You’ll


get 60% of any gains taxed as long-term holdings and that’s why it’s a prevailing strategy for avoiding taxes.

Short-term investments may reduce price risk, but they usually increase your taxes. They don’t have to. Investors using the key strategies in this chapter can shift short-term investments to long-term status and avoid being taxed to death.

When you combine these strategies with tax deferrals,

you can avoid the majority of taxes you’d normally pay. And we haven’t even considered our final principle of tax avoidance. So let’s see how it works. By using all three principles, you can reduce your taxes to almost nothing.

Using all three is the key to avoiding the IRS.

Chapter Five: See page 32


As shown in Chapter One, the current tax code created seven different tax brackets. The lowest is 10% and the highest is 39.6%, which is nearly a fourfold increase. With such a large difference, a lot of money is in play in between.

Imagine how much wealthier you’d be if most of your working life was spent in the 25% tax bracket — but you paid 10% taxes.

It’s not just the reduced taxes that make the difference. Because you’d have more money, you’d have fewer loans and pay less interest. You’d have more savings and investments that would produce more income. You could buy more productive assets that would allow you to earn more money.

Saving money creates a virtuous circle of increasing benefits. The easiest way to do it is to reduce your taxes.

The amount is magnified even more if you fall in the 28%, 35%, or 39.6% brackets. It would be a huge pay raise without having to do a thing other than becoming more tax savvy.

Of course, you can’t shift all of your taxes from your current bracket to lower ones. But you can shift a lot, and doing so makes an enormous difference in your final tax bill. In fact, most Americans could reduce their taxes by 20% or more by using this simple strategy. That’s what tax avoidance is all about.

While there are many tactics for shifting income, they fall into two categories: First, you can transfer property or other assets as gifts to your children, relatives, friends, or qualified charities (usually 501(c)(3) designated).

Second, you can hire your children or other family members, such as retired parents, to work for you. That money becomes their income and gets taxed at a lower rate. You, on the other hand, get to deduct those payments from your income. If it’s money you would have transferred to them anyway, it’s the next best thing to free money.

You don’t need an office building, employees, and 401(k) plans to qualify as an employer. Anyone can have a business just by showing a profit motive, which we’ll talk about shortly.

Gifts That Keep GivingPerhaps the easiest way to transfer assets is to give

them away, which is called “gifting” assets. By gifting assets when you’re alive, you reduce the size of your taxable estate upon death.

By gifting assets, your estate will owe fewer taxes and you can transfer more assets to your heirs rather than the IRS.

Gifting assets also produces current tax benefits as you can shift income-producing property to your children who will probably be in lower tax brackets, which in turn reduces your taxable income.

If you give to qualified charities, the amount of the gift reduces your taxable income. In most cases, it’s parents gifting assets to their children, whether minors or adults, but it could be to relatives, friends, or qualified charities.

Kiddie Tax TrapUnfortunately, you cannot give an unlimited amount

of gifts to children without tax consequences. The IRS imposes the Kiddie Tax, which is a tax applied to your child’s unearned income over $2,000. Recall

that unearned income is from interest, dividends, capital gains and other forms of returns on investments. It’s not from earned wages, whether from a job or self-employment.

The Kiddie Tax used to apply only to children under age 14. For

2013, it applies to anyone under the age of 24. How does it work? If your child earns more than $2,000 from unearned income, it’s taxed at the parents’ (or guardian’s) highest marginal tax rate. Ouch!

In other words, the first $1,000 of unearned income your child receives is tax free. The next $1,000 is taxed at the child’s rate, usually 10%. But unearned income beyond $2,000 is taxed at the parents’ highest rate, which could be 39.6% for 2013. The IRS obviously did this so that parents couldn’t gift an unlimited number of assets to children and avoid paying the higher taxes.

Be careful gifting assets if your child needs financial aid for college.

Shifting Income to Different Tax BracketsUsing Family, Businesses and Gifts to Lower the Tax Burden

[ CHAPTER FIVE ]


A word of caution though: If you’re planning to send your kids to college and need financial aid, you’ll want to consult with a tax adviser before shifting income and assets.

The Free Application for Federal Student Aid (FAFSA) form determines how much aid students receive based on their income and assets, as well as their parents’ income and assets.

As a guideline, the FAFSA assesses parents’ income at 47% and assets at 5.6% while children’s income is assessed at 50% and assets at 35%. What does this mean?

If your child has $100,000 of assets, the FAFSA expects 35%, or $35,000 of that, to be used toward education before any aid is provided.

On the other hand, if that same $100,000 was in the parents’ name, only 5.6%, or $5,600, would be expected to be used toward the child’s education.

So the more assets held in the child’s name, the less aid received. Gifting therefore makes more sense for the wealthy, who probably wouldn’t qualify for college financial aid anyway.

Gifting assets is easy. Of course, it’s a little more difficult than just saying “here you go” or “I promise to give you my gold coin collection upon graduation” and expecting the IRS to think it’s a qualified gift. For tax purposes, courts defined a gift as proceeds from a “detached and disinterested generosity.”

In layman’s terms, it means the gift must be irrevocable; you can’t take it back no matter what happens. As proof, the title must transfer to the recipient. Until title is transferred, there is no gift.

However, just because a gift must be irrevocable doesn’t mean the donor must part with 100% control over the asset. If you buy land, for example, and place your child’s name on the title as a “joint tenant with right of survivorship,” it simply means the land will transfer to the child upon your death.

Because your child didn’t pay anything for the land but now has a legal vested interest, 50% of the land’s value at time of purchase would be considered a gift.

Just about anything of value may be gifted including financial assets such as stocks and bonds, land, equipment, rare art, coin collections, livestock — you name it. If it has value, it can probably be gifted.

The gift’s value is equal to the fair market value, less anything paid by the recipient. If you give $10,000 worth of stock to your child, then that’s the value of the gift. If the child pays you $1,000 for the shares then the gift’s value is $9,000. The IRS says the donor cannot receive “full consideration” for the gift. In other words,

if you give $10,000 worth of stock and your child pays $10,000 for it, there is no gift. There must be a net benefit to the recipient.

Don’t Fear the Federal Gift TaxOne of the fears most taxpayers have with gifting

assets is they believe taxes are owed, whether by the donor or recipient. Technically that is so; but most people never have to pay one cent in gift taxes!

Recipients don’t owe taxes from the exchange unless the assets produce income. In that case, they owe taxes just on the income, but not on the gift.

As for donors, there’s a substantial annual exclusion before taxes are due. For 2013, you can give $14,000 per recipient per year to as many people as you wish — tax free.

And you wouldn’t even have to report it since it’s within the exclusion limits. Spouses can combine their annual contributions and give each recipient $28,000 per year tax free and never pay one cent in tax.

The $14,000 figure gets adjusted every few years for inflation but only in $1,000 increments. As inflation erodes the dollar’s value, the exclusion will eventually increase to $15,000, probably by 2016. But the benefits get better…

There’s also a lifetime exclusion of $5.25 million per donor, or $10.5 million if combined with your spouse’s donations. The annual $14,000 limits (or $28,000 combined) do not count against the $5.25 million lifetime exclusion.

Here’s how it works: For 2013, you and your spouse could leave two children $28,000 each, or $56,000 per year.

And because it’s within the exclusion limits, you wouldn’t have to file a federal gift tax return — and neither would your children. Your children do not have to report the gifts, unless the gifts produce income, such as with stocks, bonds, or rental property.

Example: James and Jean leave $28,000 worth of stock to their son. The shares produce $1,000 in dividends at the end of the year. Their son doesn’t have to report the $28,000 gift but must report the $1,000 income. Presumably, their son falls in a lower tax bracket so having this income reported on his tax return reduces their taxable income.

If more money is donated than allowed by the annual


limits, you won’t owe any tax, but you will have to file a gift tax return so that the IRS can keep track of your lifetime $5.25 million exclusion limit.

Example: Don and Diane leave $30,000 worth of stock to one child at the end of the year. Because this is $2,000 over the $28,000 combined limit, they must deduct $2,000 from the $5.25 million they could gift over their lifetime. While they won’t owe any gift tax, they must file a gift tax return so the IRS can be sure they’re not exceeding the $5.25 million limit. However, if they gave $28,000 on December 31 and $2,000 on January 1, they’d still be within the annual exclusion limits and would still have the full $5.25 million lifetime limit available.

You can also gift assets to your spouse in any amount

(if a U.S. citizen) and it’s always 100% tax free. When the surviving spouse dies, however, the estate is fully taxed (40% for 2013) if its value is over $5.25 million.

If your spouse is not a U.S. citizen, the gift limit is $143,000 for 2013. However, it’s usually not a good idea to gift large amounts to your spouse. If you each own similar amounts of property, large gifts can create a large estate that will increase the estate taxes upon the donor spouse’s death and make the surviving spouse worse off. That’s not much of a gift.

There is also no gift tax to qualified charities, unless you exceed annual limits. You’re allowed to deduct a maximum of 50% of your adjusted gross income (AGI), which is Line 36 on Form 1040, in the year of the donation. If you give more, you may be able to carry forward the remainder for up to five years.

Aside from gifts to people and charities, you can also realize benefits by other forms of gifting. For example, if you pay your child’s tuition, it can count as a gift but it must be paid directly to the school. However, related expenses such as books and living expenses do not qualify. Any dependents’ medical expenses that you pay directly also qualify, as do gifts to political organizations.

The Cost Basis DilemmaThe big difference between gifting assets and

transferring them after death has to do with the asset’s cost basis. Remember, if assets are transferred after the donor’s death, recipients get a step-up basis, which means their effective cost is the fair market value at the time of the donor’s death.

When gifting assets though, the donor’s cost basis is transferred to the recipient.

Example: Eric buys 1,000 shares of Gargantuan Gadgets for $20 per share. Years later, it’s worth $100 per share. If he gifts these shares to his daughter, her cost basis is $20. If she sells the shares, she’ll have to pay capital gains taxes on the $80 difference. But if the shares are transferred after death, she gets a step-up basis and her cost basis is $100 per share. She could sell the shares for the current market price of $100 and not owe any taxes. If she sells for more or less, she’ll have capital gains or losses respectively.

As a general rule, it’s not a good idea to gift assets

with capital losses. The recipient cannot deduct that loss, so that tax break is gone for good. On the flip side, if you donate things that have large capital appreciation, the recipient doesn’t pay taxes on those gains.

The Benefits of Owning a BusinessGifting assets is a strategic way of shifting taxes to

lower brackets. The second way is to hire your kids, or other relatives, to work for you. As mentioned at the beginning of this chapter, you don’t have to have a formal corporation to be considered a business.

However, business owners also receive many deductions not available to employees, and these are another source of tax savings. Let’s take a quick look at how easy it is to start a business — and how profitable it can be at tax time.

Tax laws can be broken down into two categories: those for employees and those for business owners. There’s no question that business owners get all the breaks. One of the main uses for tax codes is so the government can create economic incentives. People creating businesses are a big necessity for economic growth, and there are many tax breaks for becoming an entrepreneur.

You should never open a business just because of the tax breaks; however, if you want to be tax savvy, it provides a big incentive for starting your own business. Many tax breaks await those who take this small step.

As a business owner, you get all the deductions offered to your employees but you also get to deduct so much more, including portions of your home and children’s education.

Starting a business is easy. A simple home-based


business is all you really need to reap multiple tax benefits. Technically, if you do anything that generates income, you’re already in business. If you baby-sit, mow lawns, or do data entry for others, you have a business. To help legitimize it, though, it helps to have a tax ID number (TIN), which you can file for online. It’ll probably cost under $200 annually — and is tax deductible too. It’s a small price to reap enormous tax savings.

With today’s online world, starting a business is easy. You can get a website up in a couple of days and create a business doing what you know and love. With all the tax deductions for things you were going to buy anyway, a home-based business can be more profitable than a second job — just from the tax savings. And if your business takes off, it’s that much better.

There’s another strong reason for considering a home-based business. Today, people often have a portfolio of small jobs, since the days of easy-to-find, dependable, full-time jobs are gone. Instead, people may have a day job, run an online business, have a weekend pool cleaning service, and teach online classes at night.

That’s just the way the business world now works, and for those who rely on a single source of income, well, you’re taking a big unnecessary risk. Benefits of owning your own business go beyond the tax savings.

The first step is to find something you know and love to do. The main thing the IRS checks for is to see if there’s a profit motive, which means you are truly trying to make money. The tax laws explicitly say a true business is “any activity engaged in to make a profit.” Starting a business just to get tax deductions doesn’t count.

Here are some ideas. Consider things that you know and love — even hobbies count. Above all, be sure it’s something that fulfills a market need. As motivational guru Zig Ziglar said, “You can get everything in life you want if you will just help enough other people get what they want.”

Assume you spend lots of time on the golf course, and an inordinate amount of money on equipment, lessons, greens fees, and other expenses.

What if you started a website that sold valuable information that you’ve collected over the years? For instance, where are the best golf vacation resorts? What’s the best time to go? Maybe you could select your favorite players to win the championships for those who like to bet. You could sell small publications, from the 10 best putting tips to the psychology of winning.

The point is that it doesn’t have to be anything fancy,

but just needs to show that you’re trying to make money — that’s the profit motive.

Here’s another tip most people don’t know. What if you wanted to sell golf equipment? It sounds terribly expensive. You can just imagine what it costs to fill a warehouse complete with all the top brands. The surprising answer is that with today’s online world, you aren’t burdened with expensive overhead.

Today, many website businesses are not actual stores with warehouses and employees but, instead, affiliate sites run by a single person. The site may advertise equipment for sale, but has a larger company fulfill orders. The website owner just takes a cut of each sale.

For example, you could offer golf clubs, clothing, shoes, and all kinds of equipment on your site, but have a marketing relationship with a big sports supply company. Every time you make a sale, it automatically generates an invoice; they ship the equipment and send you a commission, say 10%. It doesn’t get any easier.

Companies are more than willing to do this since entrepreneurial website owners take time to create followings and build relationships, yet they send all sales to the supply house. It’s a great deal for the supplier as you’re acting as a non-salaried salesperson. You’d be surprised at how many stores online are actually affiliate sites and don’t carry a single piece of inventory.

In fact, there’s an e-commerce marketing program through Amazon.com where it acts as your fulfillment house for anything they sell. It’s called Fulfillment by Amazon (FBA). While Amazon was originally known for selling books, there’s not much that can’t be purchased on its site today.

If you don’t want to go through building a website, you can sell your wares or information by opening an eBay store. There are minimal setup and operational costs, and some people make millions of dollars each year selling through the online auction house.

Another interesting business model people use is through Facebook. You can begin a fan page, say for your favorite sports team or celebrity, and traffic will naturally gravitate to the page as people search for the names online.

As Facebook conversations begin, related side links called Facebook Ads redirect people to stores that sell T-shirts and other souvenirs for which you get a cut, since the traffic came from your fan page. It costs nearly nothing to create the fan page, and people are making well into six figures with Facebook fan sites that are really e-commerce businesses.

This isn’t meant to be a guide on starting up a small


business. Instead, the point is that it doesn’t take a lot of time or money to start a legitimate money-making business.

Once you do, the benefits are enormous…Taxes quickly fall. If you take your annual vacation

to your favorite golf destination, it’s not an expensive trip anymore — it’s a tax-deductible business trip. Equipment you normally would purchase for yourself is now bought to test and review for your website. It becomes tax deductible. Golf lessons that you would take anyway are now done so you can review golf pros at various locations and sell the information. They become tax deductible when related to your business.

And once your business begins to produce revenues, it adds to your income. So the benefit is magnified; you’re decreasing taxes and increasing income.

What if You Don’t Succeed?You’re allowed to have losses; in fact, most start-up

businesses produce losses for several years. But business losses can generally be deducted from other forms of income. And if your losses exceed your family’s total income, you can carry losses back two years. You’ll get a refund from the federal government and state governments if any taxes were paid there. If the losses are greater than the past two years’ of income, you can carry the losses forward for 20 years to offset future income. You’ll definitely be able to recoup any losses in one form or another.

Red Flags & Red HerringsWhile a hobby can be a legitimate business, you

must be careful to treat it like a business — not like a hobby. If the IRS thinks your business is nothing but a red herring to generate losses, it may challenge your motives and not allow the deductions.

Contrary to what most people believe, you are allowed to write off hobby expenses, but only against income produced from that hobby. But if you have a legitimate business, the IRS allows you to write off losses from that business against income from other sources, say from your day job.

Certain activities will raise red flags for the IRS, but the best way to bulletproof yourself against any doubts is to show a profit motive. While you don’t have to turn a profit, at least showing revenues will help. The IRS, along with court rulings, finds it hard to believe that any business can have zero revenues if it’s making an effort. So just having revenues is a big plus in showing you have an honest profit motive.

Three Out of Five Isn’t BadWhile revenues count, profits are better. The most

important test the IRS uses is the profit test: If you show a profit for three or more years out of five consecutive years, you are legally presumed to have a profit motive (IRC Section 183(d)) and there’s nothing else that needs to be proven.

What if you don’t show a profit despite your best intentions? No problem.

There are always exceptions. If you don’t turn a profit in three of five years, the IRS considers a nine-factor test to check for a profit motive. The more of the following nine criteria you meet, the more likely you’re considered to have a business.• How the business is run: Does your business look

like it’s run as a business — or as a hobby? What changes are you making to turn a profit?

• Expertise: Do you have past experience in the field? • Time and effort: Are you spending a reasonable

amount of time to run a successful business?• Asset appreciation: Does your business own assets

that are likely to appreciate? A profit motive may exist even if there is little revenue today.

• Successful track record: Have you run similar businesses profitably in the past?

• Unforeseen circumstances: Are the business losses due to unforeseen circumstances such as fire, flood, or economic conditions?

• Occasional profits: Do you have occasional profits that are significant when compared to the business investment and past losses?

• Financial status: Is the business your only source of income? If yes, that helps to establish a profit motive since few people depend on a hobby for financial survival.

• Personal pleasure or recreation: Is the business one that is not usually considered to have elements of personal pleasure or recreation?Courts have overruled IRS rulings many times and

use several standards to determine whether you have a business or hobby. Courts recognize that legitimate businesses sometimes do get hit with long streaks of losses, and even upheld a taxpayer who claimed losses for 12 consecutive years. The main criterion, again, is to show a sincere effort for turning a profit.

To demonstrate that, keep excellent business records. Develop a business plan and show projected revenues and expenses. Keep documentation to show your sincere intentions.

Get a business phone number, business cards,

letterhead, business checking account and other things legitimate businesses would be expected to have. By having a separate checking account, it shows the IRS you’re separating funds to make informed business decisions.

Take training classes, seminars, or purchase marketing books or other materials to show you’re trying to run a profitable business. Run ads, even if just free Internet ads.

Spending consistent time at your business is another factor the IRS considers. Even an hour or two each day carries far more weight than cramming 20 hours at the end of each month. After all, if you were in a legitimate business, you would be expected at the very least to have to answer emails and return phone calls, which would be a daily routine.

Also, watch out for unreasonable expenses. If you earned $5,000 in your business but deducted $50,000 in travel expenses, it’s going to raise eyebrows — and red flags. The IRS is likely to say you don’t have a profit motive.

Closely related to this is the income you earn from other activities. If you earn the bulk of your income from your day job, you may not be able to deduct large losses generated from your business. That’s because the losses were likely not incurred as part of earning income from your business. Instead, the IRS sees the business as nothing more than a way to generate losses to match against your true source of income.

Finally, be cautious when starting businesses that are on the IRS’ red herring list. Its radar is always on the lookout for businesses that are nothing more than a way to deduct expenses for personal use rather than a true profit motive. Activities like show dogs, horse racing, auto racing, yachting, scuba diving, antique collecting and other activities that are usually associated with personal hobbies are always suspect.

This doesn’t mean they cannot work; people do run legitimate businesses in these fields. In fact, the IRS is more lenient for the profit test for those who show dogs or race horses: If you are profitable in just two out of seven years (rather than three out of five for other businesses), you are considered to be in business.

If you’re in an industry that may be questionable, just be sure you have a well-documented business plan and are able to show a profit motive rather than appearing to just write off losses from your hobbies.

And finally, if all else fails, you can start a new business – and start a new three-out-of-five rule.

The Family’s Now Hiring!Now that you see how easy it is to start a legitimate

business, let’s find out about the tax benefits. First, you can hire family members who are in lower tax brackets, such as your children or retired parents.

However, with one exception, it’s best to not hire your spouse because your incomes are combined when you file joint returns. And if you file separately, there’s not much of an incentive and you may end up paying more in taxes. The exception is if you hire your spouse so that you can provide employee benefits. You can deduct these as a business expense, and your spouse doesn’t need to declare it as income.

Aside from that one exception, income shifting is most advantageous when hiring other family members.

Your children (or retired parents) are likely to be in lower tax brackets. By hiring them, you get to deduct their salaries from your income. The money they

earn will be taxed at lower rates too. In other words, you’ve shifted your income to lower tax brackets — that’s the tax strategy. Because it was money you would probably have paid to them anyway, it’s like free money to you.

For example, assume you make $50,000 per year, but pay $5,000 per year for your son’s basic needs such as clothing, school supplies, and other small expenses. You spend the same amount on your daughter. Those are personal expenses, which are not deductible, so you’d pay federal taxes on $50,000 income, which according to Table 1 is about $8,429.

However, if you had your own business and hired your children, things change. You could pay $5,000 per year to each child as wages for a job, which provides income for them to pay for their personal expenses. In addition, the wages paid reduce your taxable income by $10,000 so your income falls to $40,000.

Because your taxable income is $40,000, you owe $5,929 in taxes — a reduction of $2,500, or 30%.

By understanding marginal tax rates, it’s easy to see why you save $2,500. Income of $40,000 falls in the 25% tax bracket. If your taxable income falls by $10,000, your tax bill is reduced by 25% of that amount, or $2,500. Your taxes fall sharply, but your expenses remain the


By shifting income to lower tax brackets, you will significantly lower your tax bill.


same. In both cases, you spent $10,000 per year on your children. By transferring income through a business, though, you saved $2,500 in taxes. And that’s just from one tactic!

Overall, you’re better off since the $10,000 paid to your children was money that was allotted for them anyway. If you paid it to another employee, the money is gone for good. However, by shifting some of your income to your children, you retained the full use of those funds rather than throwing it to the government. And you still get to claim your children as dependents on your tax return and take the child tax credit. You’re better off and so are your children, but the benefits don’t stop there…

When you spend money on wages and salaries, your adjusted gross income (AGI) falls, which keeps you eligible for many exemptions that would otherwise be disallowed, such as adoption credits, child tax credits, and the American Opportunity/Hope Scholarship Credit.

Also for 2013, you can only claim medical expenses not covered by your insurance that exceed 10% of your AGI. The lower your AGI, the more medical expenses you can deduct. And with medical costs shooting to the stratosphere, think about the benefit if you were saddled with a pile of medical bills, especially with a high deductible.

This is a big benefit since the limit was increased to 10% from 7.5% last year. The government is reducing the amount it is willing to let you deduct, so it’s critical to get all the deductions you can.

Now That You’re Hired, Get to Work!

To qualify as true employees, your children must do actual work related to running the business. It doesn’t mean they must drive delivery trucks or run the accounting department. But they must do something that a reasonable business would be willing to pay for — and at reasonable wages. They may, for instance, answer phones, clean the office, print shipping labels, and perform other light duties. However, you may not pay them for personal services such as washing your car or walking the dog. It must be business-related work.

What are reasonable wages? The IRS accepts the “going rate.” If your child is going to do bookkeeping, find out what it would cost to hire someone in your area. If it’s $20 per hour, you may be able to stretch it to $22, but it has to at least be reasonable based on market prices.

You may pay your child any amount up to the standard deduction, which is $5,950 for 2013, and owe no taxes. If you pay more than the standard deduction, your child will have to file a tax return and pay 10% on any excess. It’s still a significant savings if you’re in the 25% bracket or higher.

Another benefit of hiring your children is that you don’t have to pay Social Security and Medicare, which is 15.4%; half is paid by the employer and half by the employee. You’ll also avoid the federal unemployment (FUTA) taxes if your child is under 21 years old.

One myth that keeps people from paying children is they believe the kids must be at least 16 years old in order to work. However, in a famous court case Eller v. Commissioner, the IRS accepted a seven-year-old as an employee. If the children are old enough to perform the work, chances are you can transfer income to them. If your child is younger than seven, it would be advisable to speak to a tax adviser for an opinion based on your situation.

One thing you don’t want to do is just fork over money to your child, telling the IRS it was for work performed. Have your child complete Form W-4 and keep timesheets. Be sure to pay by checks that coincide with regular pay periods as they do for other employees, such as every two or four weeks. Open a bank account or trust account for your child to deposit checks. Also, be sure you can verify the working hours; in other words, don’t pay your child while he or she was away at college, for example, unless the work was done virtually.

As an employer, you’ll also need to withhold taxes and file Form W-2, which shows how much you paid and the amount of taxes withheld. There are also Form 941 (Employer’s Quarterly Federal Tax Return) and Form 940 or 940-EZ (Employer’s Annual Federal Unemployment (FUTA) Tax Return). Don’t worry about these details as they can easily be filled out with any tax software or by your tax adviser.

The main point is to treat your child as you would any other employee. Link payments to work actually performed and needed by your business. Don’t just pay cash periodically or pay for school supplies and think the IRS is going to allow it as employee deductions.

Just by claiming a simple home-based business, you can shift a lot of your income to other family members — saving 25% or more in taxes. But business owners get additional breaks not available to standard W-2 employees. Nearly everything you do can be deducted against your income in some way. It’s one of the most valuable ways to avoid taxes.

The Money-Saving DeductionsBusiness owners get many deductions that usually

arise from costs of doing business. To qualify as a business expense, the goods or services must be primarily for the business, and not for personal use. The IRS says they must be ordinary and necessary for business, and most importantly, cannot be extravagant.

Of course, ordinary, necessary, and extravagant are relative words. The tax codes don’t define them, so you must use good judgment. If it’s an expense that is common and accepted in the business, it will probably be allowed.

Expenses such as rent, employee wages, retirement plan contributions, inventory, phones, business cards, software, advertising, attorney and accounting fees, bank fees, professional fees and licenses, vehicle repairs, travel, health insurance, continuing education, bad debts, charitable contributions, and taxes would be common and accepted.

And one of the most valuable to you is meals and entertainment. That’s a lot of expenses, and they’re deductible in the current year to immediately lower your taxable income. Just be aware of the caveats outlined below.

As for extravagant, it’s also a judgment call. When the Miami Heat won the 2013 championship, the players and spouses were treated to Miami’s swanky LIV nightclub — and dropped nearly $172,000 in a single night. For an organization that size, that won’t cause a problem with the IRS. It won’t work for someone selling Avon. Use your best judgment. If in doubt, leave it out.

While there are many things you can deduct, some things never count. You can never deduct government-imposed fines such as speeding tickets, parking tickets, late fees, tax penalties, and things like that. You also cannot deduct bribes and kickbacks, even if they’re commonly accepted practices. You also cannot deduct political contributions.

Before the Grand OpeningYou’ll inevitably have expenses while getting your

business up and running. You may have professional

expenses, such as legal and accounting fees, office supplies, advertising, and others. These are not costs of doing business but, instead, capital expenses, which you can deduct up to $5,000 in the first year. Any amount over that must be deducted over 15 years.

If you think your business will turn quick profits, you may consider doing a small amount of business so you can say the business is officially started. Doing so, the expenses that would normally count as start-up

costs become operating expenses, which you can deduct for the current year.

However, most businesses suffer losses in the first few years (remember the three of five rule?) and you may be better off deducting these as capital expenses over 15 years so that you’ll have some losses to offset your expected future profits.

Home Office Deductions

You may deduct a portion of your home’s expenses if you also use part of it as an office. In fact, if you’re an employee of another company and required

to work from home, you can qualify for home office deductions too.

To qualify as a home office, it must pass one of four tests: It must be your principal place of business, a place where you meet and greet clients, a separate structure, or part of a day care business.

As a business owner, to claim a home office, you must perform administrative or management roles there.

For example, if you’re a traveling salesperson and spend most of the time on the road meeting clients and making sales but wrap things up in the evening from home, even sending invoices and making plans for the next day’s routes, you can claim a home office.

However, if you do the bulk of these activities from your employer’s office and occasionally do them at home, you’re not going to be able to claim a home office. But there’s good news. Even if you could perform these duties from your employer’s office, you’re not required to. Perform them from home and you can still get your home office deductions.

You can also qualify your home as an office by the


If you mail a check, the postmark is the official date of payment according to the IRS. So if you’re mailing a check for a substantial expense and it’s the last business day of the year, be sure it’s postmarked for the current year. Also be sure to send it by certified mail too so that you have a receipt of the official time-stamped mailing date. As long as the check is mailed in the current year, the goods or services are considered to be paid for that year.


“meet and greet” test. All you have to do is meet clients in your home as part of your normal way of doing business. It doesn’t even have to be the majority of the time; instead, it must be part of your normal activities.

Owning a separate structure such as a photographer’s studio, carpenter’s workshop, or florist’s greenhouse qualifies as a home office too.

You can also qualify by using part of your home to store inventory. So if you’re an artist, you may store your paintings in a defined area of your home (such as a spare bedroom or basement) and deduct your home’s expenses associated with that area. You can use this space for some personal use too, as long as it’s primarily for business inventory.

The final way is to qualify your home as an office is to operate a day care center. Assuming you have the proper licenses to operate a day care, you can deduct the portions of your home used for running the services. Even if you use these areas for personal use after business hours, you can still claim the business deduction.

Current vs. Long-Term ExpensesYou have two categories of business expenses. The first

is current expenses (also called operating expenses) and the second is capital expenses (long-term expenses).

Current expenses are things that are expected to be used up in the first year. So things like rent, utilities, stamps, letterhead, pens, and staplers are current expenses. You can deduct these in the year purchased.

Capital expenses are expected to last for more than one year. Office buildings, furniture, vehicles, computers, software, cellphones, copyrights and patents, and other long-term assets are capital expenses. Capital expenses must be amortized; that is, you’re allowed to deduct a portion of their cost each year.

Section 179 Deductions: The Best-Kept Secret

Perhaps the best tax law for business owners is Section 179 of the tax code. It allows you to expense a long-term asset as if it was short term. You can even buy used equipment and it still qualifies.

For 2013, a big increase was given and you’re allowed to deduct up to $500,000 under Section 179. That’s up from $125,000 for 2012. You can deduct the full amount in the year purchased on one condition: It must be put in use during the same tax year; that is, between January 1 and December 31.

This can be a life saver for taxpayers. For example, assume it’s 2013 and you’re planning to spend $5,000 for video equipment for your business next year. However, you find your 2013 tax bill is $2,000 more than expected. You can buy the equipment in 2013 — even on December 31 — and put it in use to get the full deduction this year.

If you’re in the 28% bracket and pay 15.3% self-employment tax, you’re reducing your tax bill by about 28% + 15.3% = 43.3% of the $5,000 spent, or about $2,165. By purchasing the equipment in the current year and expensing it under Section 179, you have no taxes due. The best news is that you now have equipment you were going to buy anyway.

While it may seem advantageous to always deduct eligible assets under Section 179, consider future tax consequences. If you’re just starting in business, and perhaps have losses, expensing the entire amount isn’t going to benefit you. In these cases, it’s better to use ordinary depreciation methods so that you’ll likely have income to offset the losses.

Equipment & FurnitureOffice equipment and furniture are not counted

as part of the expenses of a home office. Home office deductions only apply to the cost of running the home such as interest, taxes, utilities, maintenance, and depreciation. You may, however, deduct office equipment in three different ways.

First, you can expense computers and monitors over five years. Furniture may be expensed over seven years. And if it’s advantageous, you may expense it under Section 179 and deduct the entire amount in the current year. And if you don’t use your home as an office, you may still deduct all equipment and furniture expenses for your business.

Dinners & EntertainmentWhen you’re a business owner, you can generally

deduct 50% of the total value of any meals or other entertainment. When entertaining clients, there are a few legal hurdles you must clear to qualify for a deduction.

First, your primary reason for meeting must be to discuss business — that should be obvious. But what most people don’t know is that your prospect must also reasonably expect a business reason for the meal or other entertainment.

So if you’re dining out for personal pleasure and strike up a conversation with the table next to you and


discuss some business, it’s not deductible because it wasn’t your intended purpose, and the folks at the other table had no reason to expect a business discussion with you. It was nothing more than a chance encounter so it doesn’t qualify. It must be planned and intended.

A second legal requirement is that you must discuss business before, during, or after the meal. So while you don’t have to discuss business while eating, the primary reason for getting together must be for business.

A third requirement is that the surroundings must be conducive to business discussions. Holding a meeting at a NASCAR race or rock concert would not be conducive to business discussions.

But noise is not the only factor that can disqualify your meeting place — silence can be too. If you buy tickets for a movie or Broadway play, they won’t qualify since you’re expected to be quiet during the shows, and you can’t have much of a business discussion if you can’t talk. (In the next section, though, we’ll show you how you can deduct these as associated expenses.)

The last requirement is the most important: You must document the purpose of the meeting, which includes the names of the people with you, name of the establishment, when the meeting took place, and the purpose of your meeting. While many people informally write this information on the back of the receipt, the IRS says a tax diary is required.

Whether you use a paper journal or electronic one, not only will you be within the law, you’ll find it’s easier to manage when everything’s in one place. Should you ever face an IRS audit, you’ll just need to bring your journal rather than looking for receipts in a panic.

Surprisingly, the IRS doesn’t require receipts if the expenses are under $75. Not only does this apply to business meals, but to cab fares, tips, parking meters, and other small expenses incurred while doing business. Of course, it’s always a good idea to keep them anyway. But just in case you happen to forget to pick up the receipt, or perhaps lose it, it’s not required in order to deduct the expense. Just be sure to document it in your tax journal. One thing you don’t want to do is submit the bulk of your expenses as $74.99 without receipts. Use the $75 no-receipt limit sparingly.

A misconception held by many business owners concerns deducting meals with their spouse. It’s true that the IRS doesn’t allow you to deduct meals with only your spouse. However, if your client is bringing a spouse, you’re expected to bring yours, or even significant other, to entertain the client’s spouse while you’re discussing business. In that case, your spouse’s

expenses are deductible.Further, if your client is bringing children, you could

bring yours too to keep the other kids occupied during your business discussions, and therefore your children’s expenses qualify too. Be sure to document all names, including any children, in your tax journal.

It’s easy to see where business owners could take advantage of these deductions, so be sure you don’t abuse the benefit and only deduct meal expenses that are excessive when compared to your personal meals. For example, if you deduct $10,000 for business lunches but typically spend $4,000 on personal meals, the IRS may only allow the $6,000 difference to be deducted. In other words, if it’s money you were going to spend anyway, the IRS may not allow the deduction under the “Sutter rule,” which it may invoke on impulse. Only deduct business meals when they are clearly out of the ordinary.

Associated EntertainmentJust because you can’t carry on a business

conversation at a car race or a movie theater doesn’t mean you can’t deduct these expenses. The IRS allows business owners to deduct associated entertainment, also called goodwill entertainment. To qualify, the associated expense must come before or after a qualified business discussion on the same day. If you take a client to lunch to discuss business and then play a round of golf, you may deduct 50% of the expense.

The IRS has one stipulation to watch out for: If you buy tickets to professional sports events, you may only deduct 50% of the tickets’ face value plus any applicable taxes. If you buy two tickets from a scalper for $1,000 but the face value values are $200 each ($400 total), you can only deduct 50% of the $400 total, or $200. It’s best to buy tickets from the box office or other outlet where you can get a receipt.

While meals and entertainment are usually 50% deductible, there is one main exception. If your activity is a business promotion rather than entertainment, it’s 100% deductible. For example, if you invite your client for a round of golf to demonstrate new equipment, or to a concert to demonstrate your company’s lighting and sound equipment, those are promotional efforts and 100% deductible.

Bon Voyage!For most people, flying to Hawaii would be travel, but

driving to a hotel down the road would not. The IRS says differently.


As long as you’re staying overnight, or for a long enough time to require sleep, you are traveling. Interestingly, there is no minimum distance. If you have to attend a business meeting that’s 30 minutes away but decide to go the night before to avoid traffic problems, it’s considered business travel.

There’s a reason for the distinction. If you drive a fairly long distance but return home at night, it’s not considered traveling. You can deduct 100% of these travel expenses, but you cannot deduct food and other expenses.

Staying overnight is the dividing line. Whether lodging in a fancy hotel, or crashing on an air mattress at a friend’s or relative’s home, you get more deductions. When you stay overnight, you’re also allowed to deduct on-the-road expenses, which are all those necessary to sustain life and conduct business while traveling.

By staying overnight, all meals (subject to the 50% rule) are deductible. However, all laundry, dry cleaning, tips, and others qualify as 100% deductions. In fact, you’re allowed to deduct your first laundry or dry cleaning expenses when you get home if your clothes were soiled during the trip.

As with all business deductions, the IRS doesn’t require receipts for any expense under $75. While you should always keep them, just in case you happen to dash from a taxi before grabbing one, or forget to collect that breakfast receipt, just jot the details in your tax journal.

You’re allowed to travel with your spouse too, but just cannot deduct the associated expenses unless your spouse is also employed by you. So if the hotel costs $200 per night alone and $250 for two, you can deduct $200. Just be sure you get receipts from the hotel showing the price differences.

Weekends may also count as business travel days if the costs of staying over are less than the savings on airfare for traveling after Saturday, which is usually the case. So if your meeting is scheduled to end Friday, but you can get a cheaper deal by staying through Sunday, then Saturday and Sunday are considered business days.

If you can fly to Tahiti for business and return on Friday for $2,000, but pay only $1,500 by staying through Sunday, it will pay to stay through the weekend if lodging is less than the $500 difference. The weekend will be considered business days.

Home EntertainmentYour home is assumed to be conducive to business

discussions so any entertaining you do qualifies for deductions. Unlike deducting meals, the majority of time does not need to be spent discussing business, but there must be a business motive. In fact, there is no time limit required by law. Just a couple of casual conversations about business qualify — even if the party lasts all night.

You’ll definitely want to log everyone into your tax journal, so keep the attendee list small.

And here’s another red flag for the IRS: Don’t mix business with personal events. If you are celebrating your son’s birthday, bar mitzvah, graduation, or other occasion that is considered

personal, you can bet the IRS will not allow it as a deduction no matter how much business you discussed or how well you have it documented in your tax journal. Forget about trying it for your daughter’s wedding too.

Gift GivingMost business owners send gifts to key clients for

various reasons. The IRS, however, is really tight on the gift-giving budget and only allows a maximum deduction of $25 per person per year. If you send a $200 bottle of wine to a client, you can only deduct $25.

However, if the gift is sent to a group rather than addressed to a single person, there is no limit to the gift and you can deduct 50% of the value. So if you wish to send a gift basket to a client that costs more than $25, consider sending it to the entire office and you can deduct 50% of the full amount.

Another strategy is to give entertainment gifts such as tickets to a concert, play, or other show. Doing so, you’re allowed to classify it as an entertainment expense and can deduct 50% of the full value. However, in order to deduct entertainment or meals, you must be present.

Auto ExpensesWhen you’re a business owner, you can deduct your

vehicle’s operating costs if you’re driving for business, medical purposes, moving, or for charitable services.

The following expenses are allowed:• Fuel• Insurance

Don’t mix personal events with business if you want to deduct the expenses.


• Oil changes, tires, and other routine repairs • Depreciation• Parking fees and tolls• Loan interest• Vehicle registration fees• Personal property tax• Lease and rental expense

You cannot, however, deduct travel from your home to the office. While you may think it should qualify, the IRS sees it as function of where you choose to live rather than an expense due to the business you’re conducting.

You may deduct the above expenses in proportion to the number of miles you drive for business. If 70% of your miles were for business, you may deduct 70% of the above expenses.

To do so, you must keep an accurate log of all miles

driven, the reason for the business, and other facts, which can be a hassle. Because of this, the IRS allows business owners to take a standard deduction, which for 2013 is 56.6 cents per mile for business, 24 cents per mile for medical or relocation, and 14 cents per mile for charity. If you drive 12,000 miles during the year and 70% were for business, the standard deduction would be 8,400 miles x 56.5 cents, or $4,746.

Unless you own a separate vehicle solely for business, don’t ever deduct 100% for business. It’s another red flag.

You can see that tax deductions are definitely geared to business owners — and there are countless others. You can deduct moving expenses, health insurance, business education, bad debts, taxes, and charitable contributions. You’ll find that all fall into one of the three key principles of tax avoidance.

Everyone agrees that taxes are necessary for running the country. But it’s completely unnecessary to pay more than the law requires. Doing so cuts into your income, your savings, your wealth, and your future.

If you’re not using the three key principles of tax avoidance discussed here, you are probably paying more than required. And that’s no way to build wealth.

You don’t need be overwhelmed by attempting to use all of the strategies, but at least get started. Pick a few that will provide the biggest or quickest tax savings, and speak to your tax adviser about applying them immediately for next year’s taxes. You might even be able to recoup some taxes overpaid this year. The idea is to get started. It’s the right thing to do if you’re serious about building your wealth with smart, legal tax avoidance strategies.

Your Newsmax team of financial professionals will help you to optimize the right thing, minimize the wrong thing, and escape the paralysis of doing nothing by providing the best, independent, and unbiased financial advice and information.

Conclusion:Doing the Right Things to Minimize Taxes


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DISCLAIMER: This publication is intended solely for informational purposes and as a source of data and other information for you to evaluate in making investment decisions. We suggest that you consult with your financial adviser, tax adviser, or other financial professional before making any decision that could impact your tax situation. The information in this publication is not to be construed, under any circumstances, by implication or otherwise, as an offer to sell or a solicitation to buy, sell, or trade in any commodities, securities, or other financial instruments, nor are the tax strategies mentioned an endorsement for any such tax strategy. Information is obtained from public sources believed to be reliable, but is in no way guaranteed. No guarantee of any kind is implied or possible where projections of future conditions are attempted. In no event should the content of this report be construed as an express or implied promise, guarantee or implication by or from Moneynews.com, Newsmax Media, Inc., or any of its officers, directors, employees, affiliates, or other agents that you will profit; or that losses can or will be limited in any manner whatsoever. You should consider such risks prior to making any tax decisions.

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