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8 Tax Tricks and Tactics Used by the Rich

Rich person working on a yacht
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The tax season is over, but for Americans with the means to hire tax advisers or other financial experts, tax planning often happens year round.

Generally, taxpayers must report every dollar earned and will owe taxes on the portion that’s considered taxable income. But there are many legal ways to shrink your taxable income and thus your tax liability, such as by taking advantage of tax deductions.

Many of the tax breaks that you might be familiar with are actually unavailable to the wealthiest Americans because a taxpayer must make less than a certain amount of money to qualify for them. But other methods for legally reducing your taxable income are more common among taxpayers with high incomes.

Here are a few of the best strategies the wealthy use to avoid a hefty tax bill.

Deducting business losses in a future tax year

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Businesses have expenses, like the cost of supplies or paying employees. Deducting these expenses can help reduce a business’ taxable income, meaning the portion of their income that they must pay taxes on.

If a business has a loss one year — meaning its deductions were more than its taxable income — the excess deductible expenses can be used to lower taxable income in a future year. The IRS allows business owners to carry forward a net operating loss (NOL) to a future profitable year. This NOL lowers the business’ taxable income for the future year, which means lower taxes for that year, too.

Hiring the kids

Family-run small business
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Savvy business owners know it pays to pay your kids, too. If you have a business and hire your child, the wage you pay your child is a deductible business expense that lowers your business’ taxable income.

In some situations, you won’t even have to pay half your child’s Social Security and Medicare taxes, also known as FICA taxes. That means more money in your pockets.

Just make sure your kids are actually participating in the business.

Claiming depreciation

Calculator tax savings
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Buying property or assets for your business and deducting part of the cost each year over time is a tax break referred to as depreciation. Like other business deductions, this legitimate expense translates into a lower taxable income and thus a lower tax bill for a business.

Depending on the type of property, the time period over which you can deduct depreciation might vary. IRS Publication 946 gets into the details.

1031 exchanges

House for rent
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Your real estate property goes up in value and it’s time to sell, but will you have to pay taxes on that gain? In certain situations, you can defer the gain and taxes on it by exchanging the property for like kind — essentially, roll the profit from the sale into the purchase of another property. This type of tax break is referred to as a like-kind exchange or 1031 exchange. It applies to real estate that’s used for business or held as an investment.

Ellen Joseph of Ellen L. Joseph CPA Chartered frequently see clients use the 1031 exchange to defer tax. “Most people enter into deferred like-kind exchanges by using qualified intermediaries,” such as a real estate agent or attorney, she tells Money Talks News.

However, one of the important requirements for a 1031 exchange is the time restriction. “The property owner has up to 180 days following the disposition of the old property to purchase its replacement property(ies) and still be eligible to defer some or all of their gain, provided other requirements are met,” Joseph says.

Charitable contributions through foundations

The Bill and Melinda Gates Foundation
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Enjoy giving to others? You can start a foundation with a minimum of $250,000 in initial funding to quickly lower your taxable income.

You’ll need to distribute at least 5% of the foundation’s assets each year to reap the tax benefits of a foundation. But then you can contribute up to 30% of your adjusted gross income to your foundation each year, enabling you to lower your taxable income year after year.

Within the foundation, your funds can grow without high tax costs. When a foundation sells assets like stocks, they owe a 1.39% excise tax rather than capital gain taxes.

Trusts

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You can gift assets, like cash and even property, to what the IRS calls a grantor trust to avoid paying taxes on the assets. A trust is an entity that holds property for the benefit of a person or a family, for instance. Another person, known as a trustee, controls or manages that trust.

By placing assets inside a grantor trusts, the creator of the trust, known as the grantor, gives up control of those assets and avoids paying gift taxes on them in most scenarios.

Health savings accounts

health expenses
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A health savings account (HSA) is a tax-advantaged account in which you can save money for medical expenses, though you can only qualify for an HSA if you have a high-deductible health insurance plan.

Money that you contribute to an HSA is tax-deductible. But HSAs offer more tax advantages than just lowering your yearly taxable income. If you leave funds in your HSA and allow them to grow, you won’t owe taxes on the gain when you withdraw it from the account, provided you spend the funds on qualifying health care expenses. The same goes when you withdraw your principal contribution.

To learn more about the financial benefits of an HSA, check out “5 Reasons This Is the Best Type of Retirement Account.”

Relocating

Texas road sign
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If you’re open to a move, changing residences is another tax-saving option. There are nine states that do not have a state income tax.

Avoiding state income taxes can save quite a bit of cash. In California, for example, people with incomes of more than $1 million face a 13.3% state income tax rate. So moving from California to a state without an income tax could save millionaires six figures or more each year.

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