Tax season always means a deluge of tax advice. Unfortunately, most of it is futile and lightweight.
I say that because most people work for their money rather than have their money work for them. The problem with working for your money is that you pay more in taxes as your income goes up. In fact, if your income passes $65,000 as a W-2 employee, you may find yourself being double-taxed with the Alternative Minimum Tax, or AMT.
Working hard to earn more money and then giving it away in higher taxes isn't financially intelligent, even if you do put some of it into a retirement account. On the other hand, making your money work hard for you means your earnings are taxed less, if at all.
Better Financial Advice
Recently, on a popular morning TV show, a personal finance expert recommended putting half of your tax return into your IRA, which she claimed may yield (for the average person) a whopping $25,000 gain over 40 years.
The problem with this advice is the likely decline in the purchasing power of the dollar -- inflation -- over that 40 years. I estimate that in 40 years, $25,000 will probably have the equivalent purchasing power of $250 today. Try getting excited about living on $250 when you're old.
To me, it's better to inform people about who pays taxes and who (legally) doesn't pay taxes. If you can minimize taxes or avoid paying them altogether (again, legally), you can make a lot more money today instead of having to wait, with your fingers crossed, for 40 years.
Playing by the Rules of the Rich
Years ago, my rich dad told me, "When it comes to taxes, the rich make the rules." He also said, "If you want to be rich, you need to play by the rules of the rich." The rules of money are skewed in favor of the rich, and against the working and middle classes. After all, someone has to pay taxes.
There are many ways that the rich make a lot of money and pay little to no money in taxes, and anyone can use them. As an illustration, here's a real-life situation in which I played by the rules of the rich and minimized my taxes:
• 2004: My wife, Kim, and I put $100,000 down to purchase 10 condominiums in Scottsdale, Ariz. The developer paid us $20,000 a year to use these 10 units as sales models. So we received a 20 percent cash-on-cash return, on which we paid very little in taxes because the income was offset by the depreciation of the building and the furniture used in the models. It looked like we were losing money when we were in fact making money.
• 2005: Since the real estate market was so hot, the 380-unit condo project sold out early. Our 10 models were the last to go. We made approximately $100,000 in capital gains per unit. We put the $1 million into a 1031 tax-deferred exchange. We legally paid no taxes on our million dollars of capital gains.
• 2005: With that money, we purchased a 350-unit apartment house in Tucson, Ariz. The building was poorly managed and filled with bad tenants who had driven out the good tenants. It also needed repairs. We took out a construction loan and shut the building down, which moved the bad tenants out. Once the rehab was complete, we moved good tenants in and raised the rents.
• 2007: With the increased rents, the property was reappraised and we borrowed against our equity, which was about $1.2 million tax-free, because it was a loan -- a loan which our new tenants pay for. Even with the loan, the property still pays us approximately $100,000 a year in positive cash flow.
Kim and I are currently investing the $1.2 million in another 350-unit apartment house in Flagstaff, Ariz., a hot property market.
Move Money, Don't Park It
This is an example of an investment strategy known as the velocity of money. As I've written before, moving your money makes more sense than parking it in cash, bonds, equities, or mutual funds -- the strategy most financial advisors recommend.
Kim and I have several such scenarios active at any one time. We have lots of monthly cash flow, which we reinvest, but we rarely have any liquid cash sitting around to be taxed.
In the above example, we started with $100,000 we earned tax-deferred from another investment. The $100,000 eventually allowed us to borrow over $20 million from banks, tax-free. How long would it take you to save $20 million by parking your money somewhere, as most financial advisors recommend?
Chipping Away at Taxes
Clearly, one of the reasons the rich get richer is because they earn a lot of money without paying much, if anything, in taxes. They know how to use banks' tax-free money to become richer.
Anyone can do the same. For instance, instead of paying capital gains tax on the sale of our condo units, real estate laws allowed us to defer paying these taxes and invest them into another property instead. The cash that does come from this property goes into our pockets at a lower tax rate because there's no Social Security or self-employment tax to pay, and the tax rate is further reduced by the depreciation of the property.
On the flip side, the poor and middle class toil away for their money, pay more in taxes the more they earn, and then park their earnings in savings and/or retirement accounts. In the meantime, they receive little or no cash flow on which to live while waiting for retirement -- when they'll live on their meager savings.
Doesn't it make more sense to play by the rules of the rich, and earn more while paying less in taxes?